Banking on Sustainability: Structural Adjustment and Forestry Reform in Post-Suharto Indonesia

by Christopher Barr

Christopher Barr is a forest policy scientist with Indonesia Banking on Sustainability: Structural in Post-Suharto Reform Adjustment and Forestry the Center for International Forestry Research Banking on Sustainability: (CIFOR), based in Bogor, Indonesia. As a member of CIFOR’s program on the Underlying Causes of Deforestation, hiswork has largely focused on the Structural Adjustment and Forestry changing structure of Indonesia’s wood-based industries, the role of financial institutions in funding Reform in Post-Suharto Indonesia. forestry sector investments, and decentralization of forest administration.

WWF Macroeconomics Program Office Center for International Forestry Research (CIFOR)

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Photographers Bruce Bunting/WWF Banta D. Manullay Howard Buffett Peter Rodman ACROECONOMICS M Banking on Sustainability: Structural Adjustment and Forestry Reform in Post-Suharto Indonesia.

by Christopher Barr

1 Acknowledgements

I would like to express my gratitude to the Center for Adi Resanata Somadi Halim, Trenggono Purwosuprodjo, International Forestry Research (CIFOR) and WWF- Canecio Munoz, Akie Setiawan, Mohamad ‘Bob’ Hasan, International’s Macroeconomics Program Office, which and other forest industry officials who graciously jointly sponsored the study presented in this book. responded to my requests for interviews and information In particular, I extend my sincere thanks to David about the activities of their companies. Kaimowitz for the conceptual guidance and enthusiastic support he has given to this project. His many insights I owe a debt of gratitude to Nabiha Muhamad who have broadened my understanding of the forestry reform has devoted countless hours to circulating clippings on process currently underway in Indonesia; and his forestry and finance issues from the Indonesian and commitment to supporting policy processes with well- English-language news media, which have proven to be documented research have strengthened my own extremely useful to my research. My comprehension of purpose in carrying out this study. I thank David Reed the activities of investment banks and pulp producers has for his patience and for guiding the publication and been strengthened considerably by insights from Peter dissemination of this study’s findings. Cain, one of the very few financial analysts to look seriously at the risks associated with fiber shortfalls at The research conducted for this study was funded, in Indonesia’s largest pulp mills. I also offer my sincere part, by WWF-Austria, WWF-Switzerland, and the United thanks to Nick Laird for generously sharing his expertise Kingdom’s Department for International Development. in international finance during the initial phase of WWF-Indonesia has also assisted in the dissemination this project. of some of the study’s preliminary findings. I gratefully acknowledge the support of each of these organizations. It has been my good fortune to spend much of the past Any opinions presented in the following chapters, three years based at CIFOR in Bogor, Indonesia. Several however, are those of the author and do not necessarily colleagues deserve special mention. I offer my heartfelt represent the official policy of any of these organizations. thanks to Jeff Sayer for providing the opportunity to be involved with the fine institution that he built during his During the course of my research, I was assisted by tenure as director general. William Sunderlin has my numerous friends, colleagues, and informants in both the enduring gratitude for his unflagging friendship and forestry and financial sectors who helped me to better clear-minded inputs at each stage of this project. My understand the processes I have sought to document. understanding of Indonesia’s pulp and plantations sector While it is not possible to mention each of these individ- has benefited greatly from the generous insights shared uals by name, I am grateful to all who shared their time by Grahame Applegate and Christian Cossalter. Similarly, and expertise with me. My understanding of the financial I have learned a great deal about the Indonesian Bank institutions involved in funding forestry sector invest- Restructuring Agency’s corporate debt resolution efforts ments has benefited enormously from conversations with from Bambang Setiono, who coauthored Chapter Five. Masya Spek, and I extend my deep appreciation for the I thank Lini Wollenberg for the buoyancy she offered generosity with which she has responded to my many at difficult turns in the writing process. I also greatly queries over the last two years. I thank Charles appreciate Patricia Shanley’s steady reminders to stay Joesriemerst for explaining the nuances of conglomerate focused on the people and trees for whom this study is financing in Indonesia and for sharing numerous insights ultimately dedicated. Finally, I am grateful to Ambar Liano acquired during his two decades of involvement with for handling many of the logistical details associated with timber and pulp producers. I thank Messrs. Soedibyo, this project.

2 Several of the chapters in this book have benefited from I thank Brent Nordstrom, Heike Mainhardt, and others critical feedback offered by both internal and external at the WWF Macroeconomics Program Office who have reviewers. In particular, I wish to thank David Kaimowitz, overseen the technical aspects of bringing this book into William Sunderlin, Neil Scotland, and three anonymous print. I am grateful to Sherri Alms for her fine job external reviewers for providing comments on drafts of editing the manuscript. Chapter Three, which focuses on reform of Indonesia’s HPH timber concession system, and portions of Chapter Finally, I offer my deepest appreciation to my family Five’s discussion of forestry sector debt. I thank Reed and close friends for their unwavering support for my Merrill, Arnoldo Contreras-Hermosilla, Bill Magrath, work. Whatever positive impact this study may ultimately Grahame Applegate, Christian Cossalter, and Ken have is due, in no small part, to the love, patience, and MacDicken for providing detailed comments on early encouragement that each has extended since the project versions of Chapter Four’s analysis of Indonesia’s pulp was initiated. I only hope that I am able to respond in and paper industry and portions of Chapter Five. I, alone, kind. however am responsible for any errors in fact or interpretation that this study contains. C.B. Bogor, Indonesia In addition to the substantive inputs provided by those September 15, 2001 mentioned above, a number of individuals provided critical assistance with the process of writing the chapters that follow. I express my profound thanks to Lucy Aghadjian and Richard Ryan, each of whom helped me Disclaimer: The opinions expressed in this report are the views of the author and do not necessarily represent the official policy of either CIFOR or WWF-International’s keep this process in motion when it often seemed Macroeconomics Program Office, the study’s joint sponsors. These opinions, likewise, do insurmountable. I am also indebted to Sarah Laird and not represent the official policy of WWF-Austria, WWF-Switzerland, WWF-Indonesia, the Janet Feigelstein for their assistance in regaining focus United Kingdom’s Department for International Development, or any other organization at critical junctures when the writing had stopped. involved in funding or disseminating this study.

3 Contents

Chapter 1 Introduction: Financial Crisis and Forestry Sector Adjustment 9

Sustainability as a Policy Goal 10 Restarting the Forest Sector Adjustment 11 Broadening the Reform Agenda 12 Constraints on Forest Sector Adjustment 14 Scope of this Book 16 Organization of the Book 17

Chapter 2 The Development of Indonesia’s Forest-Based Industries Under

Suharto’s New Order Regime 1966-1998 19

The Legal-Regulatory Basis of New Order Forestry Policy 20 The Rise of Indonesia’s Export-Oriented Logging Industry 21 Downstream Investment in Plywood Production 24 Diversification into Pulp and Paper Production 28

Chapter 3 Will HPH Reform Lead to Sustainable Forest Management?: Questioning the Assumptions of the “Sustainable Logging” Paradigm 37

Assumption #1: Controlling Log Supply, Without Taking Any Steps to Reduce demand for Industrial Timber, is an Effective Strategy for Sustaining the Natural Forest Resource Base 39 Assumption #2: The Most Effective Means of Restricting Indonesia’s Log harvests to a Sustainable Level is by Reforming the HPH System 41 Assumption #3: Increased Efficiency Will Promote the Conservation of Natural Forests 45 Assumption #4: Sustainable Concession Management is Profitable 49 Assumption #5: The Indonesian Government has the Institutional Capacity to Enforce the Proposed Changes in the HPH System and the Forest Products Trade 53 Conclusion: Reorienting Timber Sector Reform 55

4 Chapter 4 The Political Economy of Fiber and Finance

in Indonesia’s Pulp and Paper Industries 70

Fiber Deficits at the Mill Level 71 Large Capital Investments and High Levels of Financial Risk 77 Government Subsidies and Weak Financial Regulations 79 Access to International Finance 88 Impact of Financial Crisis and Reformasi 92 Conclusion and Policy Options 95

Chapter 5 Corporate Debt and Moral Hazard

in Indonesia’s Forestry Sector Industries 100

IBRA and Bank Recapitalization 101 Forestry Assets Pledged to IBRA 106 Capital Subsidy Through Debt Write-Off 108 Perpetuation of High Risk and Illegal Practices 111 Growing Risks for Forestry Investments 113 Debt-Driven Expansion and Moral Hazard 115 Debt Strategies of Forestry Conglomerates: Three Case Studies 117 Conclusions and Policy Options 124

Chapter 6 Revitalizing Indonesia’s Forestry Reform Agenda1 130

Acronym List 140

5 Foreword

In 1997, a major financial crisis struck Asia. In the The Center for International Forestry Research (CIFOR) wake of that crisis, the International Monetary Fund and WWF’s Macroeconomics Program Office (MPO) and the World Bank provided large loans to the commissioned this book by Chris Barr to tell that story. Indonesian government in return for their commitment Our intention was not—and is not—to attack either the to implement policy reforms intended to stabilize the IMF or the World Bank. Rather we hope this book will economy and rekindle growth. Those reforms included encourage those institutions, as well as others, to re- various measures explicitly designed to improve forest think their policies in specific ways. For example, we management, most of which focused on forest want them to pay more attention to how non-forest concessions run by large Indonesian conglomerates. policies such as monetary, financial, investment and tax policies affect forests and the rural poor. We also want The strategy those two agencies adopted had three to raise doubts about whether forest policy reforms major flaws regarding forests. First, at the same time designed to increase forest industries’ efficiency would that the two agencies were supporting forest policies necessarily lead to companies managing the forests intended to limit unsustainable logging, they also more sustainably. Finally, we want to highlight some encouraged several non-forest policies that actually specific issues, such as the rapid growth of Indonesia’s stimulated deforestation and more widespread logging. pulp and paper sector and the write-off of large amounts Second, by the late 1990s large forest concessions were of bad debts held by Indonesian forestry conglomerates, responsible for an increasingly small portion of forest which previously had not received sufficient attention. clearing and unsustainable logging. Logging outside concessions and land clearing for agriculture had One can read this book on two complementary levels. become the main sources of forest destruction. Hence, First, it tells the story of concrete events in a specific focusing on concessions dealt with only a limited piece country involving particular international agencies. of the problem. Third, a number of the specific forest This story is directly relevant for any one interested concession reforms endorsed by the IMF and the in Indonesian forest problems, the recent dramatic World Bank may have actually increased pressure economic and political changes that have taken place on Indonesia's forests. in Indonesia, or the social and environmental impacts of World Bank and IMF policies.

At the same time, this book presents much broader lessons that have strong relevance for anyone concerned about forests and the environment in other parts of the world. These lessons are not necessarily rooted in any one particular time, location, or set of actors. One such message is that forests and natural resources more generally, are not simply economic sectors and they cannot be addressed solely through sectoral policies. What happens to these resources mirrors the broader economic, social, and political priorities and trends in society. Unless one addresses these broader trends, the underlying causes of the problems, such as market and

6 institutional failures, it is virtually impossible to David Kaimowitz control the symptoms such as deforestation and Director General resource degradation. Second, we also want to Center for International highlight that societies and policy makers face many Forestry Research difficult trade-offs. Not everything in life is ‘win-win’. It would be nice if pro-market reforms that encourage David Reed greater productive efficiency would also lead to better Director environmental conditions and greater social equity, but WWF-Macroeconomics many times they do not. Society has to acknowledge Program Office those trade-offs and make difficult decisions among competing priorities and desired outcomes.

CIFOR and WWF share a common objective of making policymakers, opinion leaders, and the general public more aware of how the broad patterns of development affect tropical forests and the people whose lives depend on them. Our message to the macroeconomists and bankers of the world is pay attention to how your actions affect tropical forests and forest dwellers. Our message to the conservationists and the foresters is pay attention to the banks, both public and private. If this book leads its readers in those directions it will have served its purpose.

Introduction: Financial Crisis and Forestry Sector Adjustment

Chapter 1 In January 1998, the International Monetary Fund The IMF’s 50-point structural adjustment packet (IMF) signed a letter of intent with the Government of also included a number of policy reforms aimed specif- Indonesia (GOI) to provide US$43 billion in emergency ically at restructuring Indonesia’ s forestry sector (IMF loans to bail out that nation's collapsing economy (IMF 1998). The text of the loan agreement explains that 1998). At that point, Indonesia had been caught in its these forestry sector conditionalities were designed to current financial crisis for six months, and the Suharto raise efficiency levels in Indonesia’s timber and wood government was moving rapidly towards defaulting on processing industries and, in doing so, to promote the its balance-of-payments. Indonesia's external debt then sustainable management of the nation’ s remaining stood at US$140 billion, or approximately two-thirds of natural forests. the nation’s pre-crisis GDP (IMF 1998). The rupiah The prominent insertion of forestry conditionalities had lost 70 percent of its value since mid-July 1997, in the 1998 IMF bail-out loan agreement marked the when the Asian monetary crisis first spread to the start of an extended reform process in Indonesia’ s world’s fourth most populous country, and inflation forestry sector. Initially coordinated by the World was soaring. The nation’ s financial institutions were Bank, this process soon came to involve other mem- facing systemic insolvency, and new bank lending from bers of the international donor community through the both domestic and offshore sources had virtually Consultative Group on Indonesia (CGI). The reform ceased. agenda has been super-imposed on a process of deep In signing the IMF’ s bail-out loan agreement, the structural change in the forestry sector, the origins of Indonesian government committed itself to adopting a which pre-date the economic crisis. These changes, far-reaching set of policy reforms aimed at refloating all of which are inter-linked, include: the nation’ s failing monetary system and restoring ______long-term economic growth. Drafted by the IMF with decline in the volumes and quality of commercial input from the World Bank, this structural adjustment timber in areas allocated to forest program was designed to reorient vast segments of concession-holders; ______Indonesia’ s economy. Key components of the growing reliance by Indonesia’ s wood processing adjustment program included: industries on timber harvested through forest ______conversion; fiscal austerity measures; ______ decline in the productivity of Indonesia’s a tight monetary policy; plywood sector; ______ deregulation of major trade and investment meteoric expansion of the country’s pulp restrictions; and paper industry; ______ privatization of state-owned enterprises; decentralization and devolution of administrative ______authority in the forestry sector from the national reform and recapitalization of the nation’ s government to the provincial and collapsed banking system. district governments. ______

9 This book analyzes the prospects for effective policy believed to raise the country’s total log harvest well reform in Indonesia’s forestry sector industries during above officially recorded levels. Since 1985 when the the post-Suharto era. A central theme is that policy Indonesian government banned the export of interventions aimed at promoting environmental unprocessed logs, much of the timber extracted was sustainability will only succeed if policymakers address directed to the nation’s plywood industry at prices well the profound structural changes that have reshaped below world market rates. Indonesia’s forestry sector over the past several years. To sustain Indonesia’s rapidly diminishing forest The chapters in this study, moreover, demonstrate that resource base, the World Bank sought to reduce the forestry reform process must take into account Indonesia’s timber harvest to 25 million m3 per year economy-wide constraints, many of which fall outside of (World Bank 1995). The Bank’s strategy for accomplish- the forestry sector per se. To a very significant degree, ing this involved three specific policy objectives, which the prospects for sustainable forest management in form the core of what may be called the "sustainable Indonesia will depend on the manner in which financial logging paradigm.” First, it sought to improve the institutions evaluate the risks associated with forestry government’s enforcement of the selective cutting sector investments and how the colossal debts held by practices stipulated under the HPH timber concession Indonesian forestry conglomerates are resolved. As contract. To this end, it tried to persuade the Indonesian importantly, the scale of these groups’ forestry-related government to introduce a system of performance bonds debts underscores the degree to which Indonesia’s for concession-holders and to establish an independent macroeconomic recovery will be shaped by the success system of monitoring concessionaire activity. Second, or failure of the ongoing forestry adjustment process. the Bank sought to increase the government’s capture of timber rents by raising log royalties. Third, the Bank SUSTAINABILITY AS A POLICY GOAL sought to raise efficiency levels in all segments of log Of the two Bretton Woods institutions, the World Bank harvesting, processing, and marketing. To achieve this, was largely responsible for inserting conditionalities the Bank encouraged the Indonesian government to aimed at promoting sustainable forest management into rescind the log export ban and to allow the nation’s the structural adjustment program for Indonesia. The timber producers to obtain world market prices for Bank had pursued environmental sustainability as a their logs. policy objective in the forestry sector during the late In 1994, the Bank’s forest sector reform initiative 1980s and early 1990s through a series of three Forest came to an abrupt halt when the Indonesian government Institutions and Conservation Program loans (World rejected the third Forest Institutions loan and suspended Bank 2001). When it initiated this process, Indonesia’s the second one midstream (Gautam, et al. 2000). At the forestry sector had been open to commercial timber time, the official reason given for the government’s extraction for two decades, and the nation’s HPH (hak action was that the Ministry of Forestry was seeking to pengusahaan hutan) timber concession system was reduce its outstanding obligations by scaling back on harvesting up to 28 million cubic meters (m3) of logs per non-essential loans. World Bank and government officials year. Informal timber removals during this period, both involved in the negotiations related to the Forest by licensed concessionaires and other parties, were Institutions loans have since indicated that the reform

10 process was derailed because the policies proposed by Incorporation of the government’s Reforestation the Bank threatened powerful interests in the sector. Fund into the central government budget, and In particular, they are said to have met strong steps to ensure that the funds are used exclusively resistance from President Suharto’s close business for their intended purpose of financing associate, Mohamad “Bob” Hasan, who exerted wide- reforestation programs (point 12); ranging influence over the forestry sector through his ______position as Chair of the Apkindo plywood cartel. Reduction of export taxes on logs, sawnwood, and rattan to 10 percent ad valorem, and replacement RESTARTING THE FOREST SECTOR ADJUSTMENT of export levies with a resource rent tax (point 37); With the onset of Indonesia’s financial crisis in 1997, ______the World Bank saw an opportunity to leverage some Dissolution of the monopoly on plywood marketing of the reforms that it had been unable to accomplish in maintained by the Indonesian Wood Panel its earlier efforts. Bank officials apparently believed Association (Apkindo) (point 40); that following the nation’s monetary collapse, the ______Indonesian government was no longer strong enough Review and increase of timber stumpage to resist far-reaching policy changes in the forestry fees (point 50); sector. At the IMF’s invitation, the World Bank ______submitted several of the same concession-oriented Extension of the timber concession period and reforms that it had pursued in the early 1990s to be establishment of a system for auctioning included in the January 1998 Letter of Intent (Gautam, concessions (point 50); et al. 2000). The Bank and the IMF also inserted two ______policy interventions that were aimed more directly Introduction of performance bonds for timber at dismantling Suharto and Hasan’s discretionary concession-holders (point 50); control over the timber sector—namely, condition- ______alities requiring that the government’s Reforestation Reduction of land conversion targets to Fund be publicly audited and that Apkindo’s monop- environmentally sustainable levels (point 50). olistic control over plywood marketing be dismantled. ______The forestry-related conditionalites included in the In the months that followed the signing of the 50-point structural adjustment packet put forth by the January 1998 loan agreement, the World Bank took IMF and World Bank included (IMF 1998): steps to build on the forest sector reforms included in the initial structural adjustment package (World Bank 2001). It did so by inserting forestry-related conditionalities into two Policy Reform Support Loans, which were extended to the Indonesian government in April 1998 and April 1999, respectively. Many of the conditionalities in these two loans were aimed at operationalizing the timber concession reforms

11 articulated in the 1998 agreement. In addition, the MoFEC; the Coordinating Ministry for the Economy, Bank secured a commitment from the government to Finance, and Industry (Menko Ekuin); the National map Indonesia’s forest estate and to implement a Planning Agency (Bappenas); the major forestry mechanism for rationalizing state forest boundaries. sector industry associations; Indonesian civil society Through 1998 and 1999, the Ministry of Forestry organizations; universities and research institutions; and Estate Crops (MoFEC) showed little ‘ownership’ the European Union and several major donor coun- over the forest policy reforms put forth by the World tries; the Asian and Islamic Development Banks; and Bank, and implementation was slow (World Bank the World Bank. 2001). To a significant degree, this appears to have The post-CGI seminar provided an stemmed from MoFEC’s lingering resentment over unprecendented forum for the presentation and the Bank’s forestry intervention efforts in the mid- discussion of the many problems facing Indonesia’s 1990s (Seymour and Dubash 2000). In addition, the forestry sector after three decades of Suharto’s New Bank faced heavy criticism from Indonesian civil Order regime. Based on the most accurate data society organizations over the possibility that loans available, these presentations highlighted the fact that would be extended to a Ministry that had enjoyed deforestation in Indonesia is proceeding at a pace of lucrative benefits through its control over the 1.6 million hectares (ha) per year - or roughly twice country’s forest resources during the Suharto period. the rate that had theretofore been officially acknowledged (Toha 2000). They also initiated high- BROADENING THE REFORM AGENDA level discussion on a range of issues that had In their efforts to reform Indonesia’s forestry sector, generally been declared off-limits by the Suharto the World Bank and the IMF have worked closely administration, including the damaging effects of the with the international donor countries through the HPH timber concession system on Indonesia’s natural CGI. The CGI addressed forestry issues for the first forests; the importance of recognizing customary (or time at its July 1999 meeting, and secured an agree- adat) rights of forest-dependent communities; and the ment from the Indonesian government to host a high- role of large-scale plantation development in level forestry seminar before the CGI convened again Indonesia’s catastrophic forest fires of 1997-1998 the following February. Entitled “Removing the (Witoelar 2000). Constraints: Post-CGI Seminar on the Forestry A recent World Bank report notes that the Sector,” this meeting was held on January 26, 2000, seminar catalyzed a dramatic shift in the Indonesian one week before the full gathering of the CGI government’s recognition of the urgent need for (Keating 2000). forest policy reform: The post-CGI seminar proved to be an important In an address to the CGI on February 1, 2000, milestone for Indonesia’s forestry adjustment process. MoFEC acknowledged that management of It brought together a broad range of stakeholder Indonesia’s forests has for the past 32 years groups, among which coordinated action will be emphasized timber extraction and that the ‘alarming necessary if forestry sector reform is to succeed. rate of deforestation’ that has been one of the results Participants included senior officials from the is a matter of national and international concern.

12 The Ministry highlighted illegal logging, overcapacity set forth by a Presidential Decree to ensure high-level in wood-processing industries, conversion for participation across ministries; would involve govern- non-forest uses, conflict in forest areas between ment agencies at the district, provincial and national government control and adat rights, and forest fire as levels; and would be carried out in a transparent critical problems that cannot be resolved without manner to secure input and support from Indonesian interdepartmental cooperation within the govern- civil society. ment and participation from all forest stakeholders. Third, the government agreed to take Stating that sustainable development in Indonesia immediate action to address eight urgent issues cannot be achieved without sustainable forest facing Indonesia’s forestry sector (Keating 2000). management, the Ministry issued a ‘long-term These actions include: ______commitment to put our forests back to their coordinated action against illegal loggers, functions....’(World Bank 2001). especially within national parks, and the closure The post-CGI seminar led to three formal commit- of illegal sawmills; ______ments on the part of the Indonesian government accelerated forest resource assessment as a basis related to forestry sector reform (Keating 2000; for NFP formulation; World Bank 2001): ______First, the government agreed to create an Inter- re-evaluation of conversion forest policy and a Departmental Committee on Forests (IDCF). The moratorium on all natural forest conversion purpose of the IDCF was to formulate a National until NFP agreed; ______Forestry Program (see below) and address key policy downsizing and restructuring of the wood-based reforms identified at the post-CGI forestry seminar. industry to balance between supply and demand Members of the CGI have argued that the formation of for raw material and to increase the an inter-departmental committee was an important competitiveness of the industry; step in dealing with the cross-sectoral nature of the ______major pressures on Indonesia’s remaining natural closure of heavily indebted wood industries forests. Some have also quietly noted that the IDCF under the control of the Indonesian Bank played an important function in pulling the forestry Restructuring Agency (IBRA) and linking reform process out of the Ministry of Forestry and proposed debt write-off to capacity reduction; ______Estate Crops, which was often reluctant to accept the connecting the reforestation program with the interventions proposed by the international donor needs of forest industries; community. ______Second, the government agreed to formulate recalculation of the real value of timber; a National Forestry Program (NFP). The purpose ______ of the NFP was to set forth a comprehensive strategy using the decentralization process as a tool to enhance sustainable forest management. for ensuring the sustainable management of ______Indonesia’s remaining forest resources. The government agreed that the NFP process would be

13 CONSTRAINTS ON FORESTRY SECTOR ADJUSTMENT specific policy interventions proposed. It is important Despite the Indonesian government’s high-level to note, moreover, that while some of these constraints commitment to forestry reform, few positive changes could have been anticipated and addressed by the have occurred in the sector since the February 2000 World Bank, IMF, and CGI, others decidedly could not CGI meeting. To be sure, the government followed have been. Briefly, these five factors include: through on its agreement to convene an Inter- Departmental Committee on Forests, and since July Poor preparation: The World Bank’s general lack of 2000, the IDCF has held several working group meet- preparedness for reentering Indonesia’s forestry ings on the eight specific policy reforms it is charged sector in 1998 meant that valuable time and political with implementing. The Committee, however, has capital were lost during the initial phase of the been slow to act and its member agencies have shown adjustment process. A study by the World Resources little effective coordination on any of these eight Institute (WRI) identifies three key areas in which issues, with the partial exception of illegal logging poor preparation undermined the Bank’s performance (World Bank 2001). At the April 2001 meeting of the (Seymour and Dubash 2000). First, the forest sector CGI, the government was likewise able to report little conditionalities attached to the January 1998 discernible progress in formulating the National agreement were inconsistent and incomplete. To a Forestry Program. large extent, this stemmed from the World Bank’s lack By mid-2001, forestry sector adjustment in of engagement in the forestry sector for the four years Indonesia had, for all practical purposes, stalled. This preceding the crisis, which left Bank staff without “the has led many participants in the reform process to benefit of updated analysis or stakeholder consultation reflect critically on the policy interventions put forth to support the design of those conditions.” Second, the by the World Bank and the IMF, and more generally forestry conditionalities attached to the IMF’s original the CGI, in the four years since the 1997 financial Letter of Intent were poorly articulated in that they crisis. It has raised important questions, on the one failed to specify desired outcomes and in some cases, hand, about why the policy changes implemented by were attached to unreasonable deadlines. Third, the the government have had little impact in slowing forest World Bank failed to cultivate ‘ownership’ of the degradation and loss; and on the other hand, why the forestry reforms among key constituent groups, government has failed to carry out many of the particularly among domestic and international NGOs. reforms it has agreed to. As significantly, it has encouraged policymakers to reconsider the types of Institutional constraints: The pace and effectiveness policy interventions most likely to promote sustainable of the forestry adjustment process has often been forest management under the conditions that currently constrained by the Indonesian government’s own exist in Indonesia. institutional limitations. In particular, lack of coordina- Five factors have undermined the effectiveness tion between the Ministry of Finance, which has of the forestry adjustment process in Indonesia over negotiated and overseen the structural adjustment the past four years. The relative importance of these loans, and the Ministry of Forestry has frequently factors has varied over time and in relation to the meant that the latter has little sense of ownership or

14 accountability for implementing the World Bank and Misguided policies: During the initial phase of forestry IMF conditionalities (Seymour and Dubash 2000). adjustment, the policy interventions put forth by the More generally, the Indonesian presidency has World Bank and the IMF focused almost exclusively on changed hands four times since the onset of the finan- reforming Indonesia’s HPH timber concession system. cial crisis in mid-1997, and each of these transitions has To a significant degree, the proposed reforms were been accompanied by extensive changes in the based on an outdated understanding of the major government’s senior policymaking staff. Moreover, the dynamics at work in Indonesia’s forestry sector. process of reformasi following the collapse of Suharto’s Analysis of these interventions suggests that even if New Order regime has involved frequent reshuffling of they were fully implemented, these policies would be administrative responsibilities among government highly unlikely to reduce log removals to a sustainable departments. The Ministry of Forestry, for instance, level. On the contrary, the reforms pose new threats to was combined with Estate Crops in 1998; separated the nation’s forests in that several of the policies again in 1999; relegated to directorate status under the encourage increased rates of timber harvesting. Ministry of Agriculture in 2000; and restored to ministerial level in 2001. Sectoral focus: The forest sector conditionalities put forth by the international donor community have Decentralization: A process of decentralization that largely been sectoral in nature, generally ignoring was begun during the New Order period has domi- extra-sectoral pressures on Indonesia’s forests. This nated Indonesia’s political economic transition since was particularly the case during the first two years the fall of Suharto. In the forestry sector, provincial following the 1997 crisis, as the World Bank and IMF and district governments have assumed considerable interventions were aimed at raising efficiency levels in portions of the administrative authority theretofore the timber and wood processing industries. Some held by the national government. In practical terms, extra-sectoral pressures were addressed in the policy this has meant that the Ministry of Forestry no longer commitments adopted by the government at the holds primary responsibility for land-use planning, February 2000 CGI meeting - most notably, the role of allocation of timber concession permits, or enforce- Indonesia’s Bank Restructuring Agency in writing off ment of logging regulations in large portions of the corporate debts held by forestry conglomerates. nation’s forest estate. The World Bank and interna- However, implementation of the commitment on debt tional donor agencies certainly cannot be faulted for apparently has been delayed by Indonesian policy- failing to anticipate the very rapid pace that decentral- makers’ difficulties in working cross-sectorally, in spite ization has taken in post-New Order Indonesia. of the CGI’s efforts to facilitate inter-ministerial Nonetheless, the effectiveness of the forestry collaboration. adjustment process has been limited by the fact that most of their policy interventions were negotiated with and designed to be implemented by the national government.

15 SCOPE OF THIS BOOK overlooked by policymakers involved in the forestry The objective of this study is to analyze the prospects adjustment process. This lack of attention is for policy interventions aimed at promoting sustainable paradoxical given that over US$12 billion has been forest management in three important arenas: invested in these industries since the late 1980s and ______Indonesian pulp mills consumed over 100 million m3 HPH concession management and timber trade; of wood from natural forests between 1988 and 1999. ______Moreover, the failure of major producers to bring Pulp and paper expansion and financial risk adequate areas of pulpwood plantations into production assessment; and has meant that the country’s largest mills are now ______facing fiber supply deficits, which carry significant Corporate debt resolution. financial risks. Indonesian pulp and paper producers ______have made large-scale investments in high-risk projects To be clear, this study does not aim to provide a both because these enterprises have been heavily detailed analysis of the forestry sector reform process subsidized and because financial institutions have that has occurred in Indonesia since the onset of the failed to adequately assess the risks involved. 1997 crisis. Nor does it offer a comprehensive policy The issue of corporate debt held by forestry agenda for addressing the multitude of pressures conglomerates was incorporated into the eight under which Indonesia’s remaining natural forests commitments adopted by the Indonesian government currently exist. The study aims, rather, to identify a at the February 2000 meeting of the CGI. At that time, handful of strategic policy levers—both within and it was estimated that Indonesian forestry and estate outside of the forestry sector—that can be used to crop conglomerates were carrying US$4.1 billion in promote more sustainable forest management prac- outstanding domestic debt and that US$2.7 billion of tices on the part of Indonesia’s forest-based industries. this sum represented non-performing loans managed Of the three policy arenas examined, the first— by IBRA. These conglomerates also held over US$15 HPH concession management and timber trade— billion in outstanding debts to offshore creditors. At is, by far, the most closely related to the forestry the CGI meeting, the government agreed to close adjustment process that has occurred in Indonesia. heavily indebted wood processing industries under Indeed, the World Bank focused its initial reform IBRA in order to ensure that these groups did not efforts almost exclusively on improving concession receive a capital subsidy through debt write-off. To management practices and raising efficiency levels date, however, the government has done little to throughout the timber sector. As such, the analysis address this commitment. offered in this study closely examines the specific This lack of action can be attributed largely to policy interventions put forth by the World Bank, sectoral thinking: Ministry of Forestry officials have and reviews the assumptions underlying each. shown little interest in or capacity to formulate a By contrast, expansion of Indonesia’s pulp and strategy to ensure that indebted forestry paper industries, and associated plantation develop- conglomerates repay their financial obligations. ment efforts, is an arena that has been largely Finance sector officials, likewise, have shown little

16 inclination to incorporate technical forestry data Chapter Six offers conclusions and recommendations into the process of corporate debt restructuring. for strengthening the forestry reform efforts currently The recent financial collapse of Asia Pulp & Paper, underway in Indonesia. Indonesia’s largest pulp and paper conglomerate, highlights the considerable degree of moral hazard It should be noted that the chapters of this book were associated with Indonesia’s forestry sector debts. written over a two-year period from mid-1999 to mid- 2001. As such, they are in many respects not entirely ORGANIZATION OF THE BOOK up-to-date with current developments in Indonesia’s The book is organized into six chapters: forestry sector. In particular, the far-reaching effects of the decentralization process in the forestry sector do Following this one, Chapter Two traces the not receive adequate attention. However, it is hoped development of Indonesia’s forest sector industries that readers will recognize that the value of these under the New Order regime (1966-1998). chapters lie less in their details than in their overarching conclusions. Chapter Three analyzes the likely effectiveness of Perhaps the most important theme presented in the World Bank’s efforts to achieve environmental the following chapters is that if Indonesia’s remaining sustainability in the forestry sector by reforming natural forests are to be managed sustainably, the the HPH timber concession system and improving institutional actors involved in the forestry adjustment efficiency in wood-based industries. process will need to recognize the structural changes now occurring in the sector. For the policy process, Chapter Four analyzes the factors encouraging this implies a need to shift emphasis away from large-scale investments in Indonesia’s pulp and improving the management practices of HPH timber paper sector at a pace that far exceeds efforts to concession-holders and toward dealing effectively with secure a sustainable fiber supply through plantation the problem of overcapacity within Indonesia’s wood development. In particular, it examines the failure of processing industries. Just as importantly, the future of both domestic and global financial institutions to fully Indonesia’s forests will depend on how the govern- assess the financial risks involved with pulp and ment and the international community choose to paper projects. resolve the country’s corporate debt crisis and restructure its financial sector. The prospects for Chapter Five examines the process through which sustainability will also depend on the degree to which forestry conglomerates are securing capital subsidies global financial institutions—investment banks, export through corporate debt write-off under IBRA and credit agencies, and brokerage houses—adequately through restructuring arrangements with offshore assess the financial risks associated with investments creditors. Particular attention is given to the moral in Indonesia’s forestry sector industries. hazard issues associated with poor due diligence practices and the refinancing of high-risk enterprises.

17 Chapter One: Sources Cited Toha, Moch. 2000. “Estimated Deforestation Rate for Indonesia.” Gautam, Madhur, Uma Lele, William Hyde, Hariadi Kartodihardjo, Unpublished presentation prepared for the CGI Seminar on Azis Khan, Ir. Erwinsyah and Saeed Rana. 2000. Indonesian Forestry. Jakarta. January 26. “The Challenges of World Bank Involvement in Forests: Witoelar, Wimar. 2000. “Forestry Woes Reflect An Evaluation of Indonesia’s Forests and World Bank Local Tragedy.” Jakarta Post. February 3. Assistance.” Operations Evaluation Department, January 6. World Bank. 2001. Indonesia: Environment and Natural Resource International Monetary Fund. 1998. “Indonesia—Memorandum of Management in a Time of Transition. Washington, DC: Economic and Financial Policies.” dated January 15. Jakarta: World Bank. http://www.imf.org. World Bank. 1998. “World Bank Involvement in Sector Adjustment Keating, John. 2000. “New Hope for Indonesia’s for Forests in Indonesia: The issues.” Forests.” Jakarta Post, February 7. Unpublished Draft Issues Paper. October. Seymour, Frances J. and Navroz K. Dubash. 2000. World Bank. 1995. “The Economics of Long Term The Right Conditions: The World Bank, Structural Management of Indonesia’s Natural Forest.” Adjustment, and Forest Policy Reform. Washington, Unpublished Paper. August. DC: World Resources Institute. World Bank. 1993. “Indonesia—Production Forestry: Achieving Sustainability and Competitiveness.” Unpublished Draft Working Paper. October.

18 The Development of Indonesia’s Forest-Based Industries Under Suharto’s New Order Regime 1966-1998

Chapter 2 Indonesia has the world's third largest tract of tropical Rise of commercial timber extraction: The New Order forests, surpassed in area only by those of Brazil and government took control over the nation's vast forest the Congo. In 1997, the country's total forest cover was resources in 1967, and initiated a process through officially estimated to be 100 million ha (MoFEC, cited which it would distribute over 60 million ha of timber in World Bank 2001). The natural forests of Kalimantan concessions to privately owned companies (Brown and Irian Jaya, in particular, are among the most 1999). During the 1970s, Indonesia was the world's biologically diverse ecosystems on earth, with each largest exporter of tropical timber, shipping nearly containing over 900 species of flora, between 34 and 300 million m3 to international markets. 55 percent of which are endemic (MacKinnon, et al. 1996). It has been conservatively estimated that at least Growth in domestic wood processing: In the mid- 20 million people depend on Indonesia's forests for 1980s, the government imposed a national ban on the bulk of their livelihoods (Sunderlin, et al. 2000). log exports to catalyze downstream investment in The forests of Indonesia's Outer Islands1 remained plywood production. By the end of that decade, largely intact until the inception of Suharto's New Indonesia had 132 plywood producers capable of Order regime in 1966. Over the ensuing 32 years, producing over 12 million m3 of panels per year however, approximately 40 million ha of natural forest (Apkindo 1990). Indonesia's wood panel industry are believed to have been lost, and a much larger area supplied over 70 percent of the world's tropical of forest left in degraded condition. Between 1985 and plywood exports through the 1990s and generated an 1998, deforestation is estimated to have occurred at an average of US$3.5 billion in annual export revenues. average pace of 1.6 million ha per year (Toha 2000). To Under Suharto, the Indonesian Wood Panel Producers a large extent, this rapid loss of forest cover was driven Association (or Apkindo) exercised monopolistic by the New Order state's promotion of forest-based control over plywood exports, channeling enormous industries for macroeconomic development and its profits to Mohamed “Bob” Hasan, one of the utilization of forest resources as an important form of President's closest associates. political patronage. Through the Suharto period, Indonesia's forestry sector ranked second only to the Expansion of pulp and paper production: Between petroleum sector in its contribution to the country's 1987 and 1997, the nation's pulp and paper production gross national product (GNP). capacity grew by nearly sevenfold to reach 3.9 million This chapter traces the growth of Indonesia’s tonnes and 7.2 million tonnes per year, respectively forest-based industries under the New Order regime. (APKI 1997). This expansion has placed new structural It describes, in particular, three general stages of demands on Indonesia's forest resources, as pulp forestry sector development: production on this scale entails the consumption of approximately 20 million m3 of fiber. To assist Indonesian pulp producers in obtaining raw material 1 The term ‘Outer Islands’ is used to refer to all of Indonesia’s islands other than the densely-populated Java and Madura. Systematic timber for their mills and in keeping their production costs extraction in the teak forests of Java has been carried out by successive colonial among the lowest in the world, the New Order state and post-colonial states since at least the early 17th century (Peluso 1992). provided heavy subsidies for the development of

19 pulpwood plantations. Through 1997, the government communities to national forestry law and policy. allocated 4.5 million ha of forestland to pulp producers To set forth a comprehensive legal and administrative for staged clear-felling followed by the planting of fast- framework for managing the nation's forest resources, growing hardwood species. the BFL delineated four functional categories to classify the land encompassed in the forest estate (Barber THE LEGAL-REGULATORY BASIS and Churchill 1987). These included protection forest; OF NEW ORDER FORESTRY POLICY production forest; nature conservation forest; recrea- Large-scale logging began in Indonesia's Outer Islands tion forest. In the late 1980s, a fifth category, conver- in the late 1960s, shortly after the New Order regime sion forest, was adopted to cover degraded forest lands came to power. Following the transfer of formal designated for permanent conversion to other uses. political authority from Sukarno, the Republic's first The BFL laid the basis for commercial president, to Suharto in March 1966, the new regime's exploitation of Outer Island timber by giving the state leadership was confronted with a domestic economy forestry bureaucracy the authority to grant a “Right that was at a virtual standstill, soaring inflation, and a of Forest Exploitation” (Hak Pengusahaan-Hutanor, ballooning foreign debt, as well as widespread HPH) to state-owned corporations and to private absenteeism within the state bureaucracy (Anderson investors in areas classified as Production Forest. 1990). Deep internal divisions also existed within the The HPH contract provided the concession holder Indonesian military, and at that point, Suharto's own with nontransferable logging rights to a discrete area power base was largely limited to Java's Diponegoro of production forest for a period of 20 years.2 In a Division and Army Intelligence, each of which he had strictly technical sense, the HPH contract required headed in the years preceding his ascent to the concessionaires to adhere to what the Forestry presidency (Crouch 1988). Within this context, the Department defined to be principles of sustainable New Order's senior officer corps saw the rich forest management under its “Indonesian Selective dipterocarp forests of the Outer Islands to be both a Cutting” system (Tebang Pilih Indonesia). Specifically, ready source of foreign exchange and a valuable HPH holders were prohibited from harvesting stems resource that could be distributed through informal with a breast diameter smaller than 50 cm and were patronage networks to bolster its own political legiti- required to manage their concessions according to macy at all level of the state apparatus (Barr 1999). a 35-year cutting rotation.3 In May 1967, New Order policymakers adopted Indonesia's first Basic Forestry Law (Undang-Undang 2 The specific terms of the HPH contract were detailed in Government Regulation 21 of 1970. See Barber (1990) and Gray and Soetrisno (1989) for a fuller discussion of Dasar Kehutanan, hereafter BFL), which gave the the HPH contract and Indonesia’s timber exploitation laws. state comprehensive legal-regulatory jurisdiction over 3 In formulating these requirements, forestry policymakers assumed that logged-over 143 million ha—or roughly three-quarters of the forest would naturally regenerate at an average rate of 1-2 m3 per hectare per year, and as such would be able to sustain a selective harvest on average every 35 years. nation's land area (Barber 1990). In defining this area To promote concessionaire compliance with the HPH contract, the Forestry Department as state-controlled “forest estate” (Kawasan Hutan), required that private timber operators submit for approval 20-year, 5-year, and annual work plans. Approval of the yearly work plan was supposed to involve cruising of the the regime's leadership effectively subordinated the applicant’s logging block by provincial forestry officials in order to determine the traditional (adat) rights of forest-dependent company’s annual allowable cut (AAC).

20 The New Order state's framework for rent capture THE RISE OF INDONESIA’S in the timber sector involved the collection of a variety EXPORT-ORIENTED LOGGING INDUSTRY of fees and royalties, which were modified both With the establishment of the HPH concession system, quantitatively and qualitatively over time. The main the Forestry Department opened Outer Island forests instruments of rent collection included the following: to commercial timber extraction in 1967. This triggered ______a rush among both multinational logging companies HPH License Fee (Iuran Hak Pengusahaan and domestic entrepreneurs, particularly among Hutan, or IHPH): an area-based fee collected Indonesia's ethnic-Chinese minority, to obtain HPHs annually from concessionaires. that were well-stocked with commercial timber species. ______The largest of these investors often entered into Forest Product Royalty (Iuran Hasil Hutan, or partnerships with military officers or politico-bureau- IHH): an ad valorem fee on each unit of timber cratic power holders, scores of whom received HPHs harvested, depending on species and grade. ______from the New Order leadership in order to secure Timber Export Tax: an ad valorem tax on all their loyalty to the Suharto regime (Ross 2001). exported wood, differentiated according to In such ventures, the military or bureaucratic species and grade. stakeholder generally functioned as a “silent partner,” ______receiving a 20 to 25 percent equity share in the enter- Reforestation Guarantee Deposit (later changed prise by virtue of the fact that it had secured the con- to a nonrefundable Reforestation Fee): cession and would provide political protection. The introduced in 1980, this stumpage-based fee was foreign or ethnic Chinese investor would contribute officially introduced to ensure that concession the bulk of the venture's investment capital, equipment, holders would replant harvested areas but later and day-to-day management of the logging operations. became the largest tax on the timber industry. Allocating HPHs according to discretionary, nonbid- ______ding procedures, the Forestry Department distributed Provincial and sub-provincial state agencies also 519 timber concessions, covering 53 million ha, collected a variety of lesser fees from private timber between 1967 and 1980 (Barr 1999). operators, including a regional development royalty, log The legal-regulatory framework and the policy pond and grading fees, as well as transport and port environment that the state put in place to encourage levies. In setting this schedule of fees and royalties for private capital investment in the timber sector rapidly the forestry sector, New Order policymakers initially generated large volumes of log exports and exchange underpriced Indonesian timber quite considerably both earnings. As Table 2.1 indicates, Indonesia's log in terms of the stumpage value of the wood and in rela- production rose by 470 percent during the first eight tion to the fees that logging companies were required years of the New Order period, climbing from 6.0 to pay in nearby timber-producing countries (Gillis 1988). million m3 in 1966 to 28.3 million m3 in 1973. As In doing so, they created a system in which the majority significantly, the recorded volume of log exports during of timber rents generated from a logging concession this period rose from 334,000 m3 to 18.5 million m3. By would flow to the HPH holder, not to the state. 1973, Indonesia's logging industry generated US$562

21 million, or 18 percent of the nation's total exchange reported volumes (Kartodihardjo 1999). Logging earnings (Barr 1999). companies regularly cut areas that exceeded those While the timber sector's contribution to GNP documented in their annual work plans, and HPH dropped substantially following the 1973 oil boom, holders frequently harvested forests located outside Indonesia's log export levels and the revenues they their concessions. In some provinces, illegal logging produced reached new heights in the late 1970s. teams also conducted unauthorized operations in state- The known volume of unprocessed timber shipped owned forests or within the boundaries of HPHs held overseas exceeded 20 million m3 per year during 1976- by legitimate timber operators. 78, when Indonesia supplied 44 percent of world Several structural factors made these systematic hardwood log exports. Moreover, annual earnings transgressions of the HPH contract and related timber from log exports exceeded US$1.5 billion during the regulations possible. Most fundamentally, perhaps, the timber boom of 1979-80. HPH contract itself was weak, delineating only general Through the 1970s, a very significant portion of principles for timber company behavior but providing the exchange earnings produced by Indonesian log few specific guidelines for companies to follow (Gillis exports remained in the hands of private timber 1988). For instance, the fact that the annual allowable operators. Indeed, the official taxes, fees, and royalties cut was set at 1/35 of the total concession area gave collected by the various government agencies in the private timber companies an incentive to log areas timber sector amounted to only a fraction of the actual outside those indicated in their official workplans in rents arising from forest exploitation in the Outer order to fully exploit their HPHs during the 20-year Islands. Ruzicka (1979) estimates that the state contract period. captured between 25 and 33 percent of the total rents In addition, the state forestry bureaucracy lacked generated by timber operators in East Kalimantan the human resources and institutional structures during the period 1973-77. A more recent study for necessary to effectively monitor concession manage- Indonesia's Ministry of Finance suggests that the ment practices in the vast areas allocated to private state's rent capture may have actually fluctuated logging companies. Most of the largest timber opera- between 15 and 27 percent during this period tors, moreover, were tied to military or politico- (Haughton, et al. 1992). In other words, private conces- bureaucratic power holders, who provided them with sion holders were able to pocket between 67 and 85 a considerable degree of regulatory immunity. The percent of the returns from their logging activities widespread involvement of state elites in the timber above and beyond a normal rate of profit, which is industry meant that Forestry Department efforts to generally assumed to be 15 percent per year. enforce the HPH contract were generally mediated by The formal profit flows generated by the state's the interests that particular concession holders policy of rapid timber extraction, in fact, accounted for represented. only a portion of the accumulation that occurred in the The collusion of government officials in timber sector during this period. Indeed, some indus- circumventing timber regulations was not limited to try analysts have argued that actual timber removals the protection of well-connected logging companies by by HPH holders were approximately twice the national state elites. Rather, timber was an important

22 form of booty for individual officials and institutional in order to extract a variety of illegal fees and, in power holders at all levels of the state apparatus, most some cases, to obtain a portion of the logs harvested. of which received formal salaries and budgetary It was not uncommon for provincial officials to engage outlays that met only a portion of their personal and legitimate timber operators in production-sharing organizational expenses. Regional military commands arrangements to log state-owned forestlands located and forestry officials in the Outer Islands frequently outside the boundaries of those operators’ concessions. worked together to extract profits from the timber By the same token, provincial timber syndicates resources within their jurisdictions (Sacerdoti 1979). sometimes used their coercive power to conduct illegal These groups regularly provided ‘protection’ and logging operations within existing HPHs, with or bureaucratic ‘handling’ services for concession holders without the consent of the concession holder.

Table 2.1: Indonesian Log Production and Exports (1965-1980)

Year Production Export Volume Nominal Export Real (1980) (‘000 m3) (‘000 m3) Earnings Export Earnings (US$’000) (US$’000) ______1965 5,815 209 2,618 6,836 ______1966 6,044 334 3,886 9,863 ______1967 6,587 590 7,815 19,296 ______1968 7,339 1,552 15,590 36,943 ______1969 8,934 3,728 29,347 62,308 ______1970 12,614 7,850 86,341 175,847 ______1971 15,696 10,848 163,960 322,756 ______1972 18,870 13,930 229,082 425,013 ______1973 28,297 18,523 562,013 939,821 ______1974 25,321 16,897 703,658 1,176,686 ______1975 18,781 14,746 439,948 673,734 ______1976 25,939 20,055 841,452 1,144,833 ______1977 28,825 20,127 925,409 1,168,456 ______1978 27,801 20,694 936,406 1,182,331 ______1979 24,109 19,517 1,579,468 1,792,813 ______1980 24,662 16,314 1,559,303 1,559,303 Total______294,870 185,914 10,660,839

Source: FAO, Yearbook of Forest Products (various years)

23 DOWNSTREAM INVESTMENT of Outer Island concessions became concentrated into IN PLYWOOD PRODUCTION the hands of a relatively small number of integrated In the early 1980s, state policymakers began to timber conglomerates, which linked large-scale prioritize the development of an internationally com- logging operations with plywood production. petitive plywood industry in Indonesia and took a By the mid-1990s, the 10 largest of these groups series of decisive steps to push private timber firms to controlled 228 HPHs, covering over 27 million ha or 45 shift their operations downstream. Most dramatically, percent of the 60 million ha that had been allocated to the Directors General of Forestry, Multifarious private timber operators up to that point.4 As Table 2.2 Industries, Domestic Trade, and Foreign Trade jointly shows, these groups also owned 48 of the nation’s 132 announced in April 1981 that a national ban on log plywood firms in 1990, accounting for just under 40 exports would be introduced in phases by the end of percent of the wood panel industry’s total production 1984. Effectively cutting off Indonesian-based logging capacity. companies from international timber markets, the log export ban forced HPH-holders to invest in plywood Apkindo and the Strategic Marketing of Indonesian Panels production if they wanted to maintain access to the The log export ban was phased in at a time when often exorbitant timber rents that they had enjoyed many of the world’s major plywood export markets thus far. were locked in an extended recession and demand By 1985, 101 plywood producers had brought for Indonesian panels was low. Recognizing that direct processing operations online—up from 21 just six competition among Indonesian producers posed a years earlier—and the nation’s wood panel industry serious threat to the timber industry’s overall prof- had an annual production capacity of 6.5 million m3 itability, New Order policymakers took steps during (Apkindo 1986). The industry continued to expand the early 1980s to regulate the nation’s plywood rapidly through the late-1980s, and by 1990 Indonesia exports. They did so by giving Bob Hasan far-reaching had 132 plywood producers capable of generating authority to transform the Indonesian Wood Panel 12.6 million m3 of panels per year (Apkindo 1990). Association (Asosiasi Panel Kayu Indonesia, or The New Order state’s policy of pushing private Apkindo) into a collective marketing apparatus with logging companies to invest in plywood production cartel-like powers (Barr 1998). also effectively concentrated control and ownership of Shortly after being named chair of the producers’ capital in the timber sector. In response to the state’s association in December 1983, Hasan installed a disciplinary measures, which included increasingly marketing commission for Apkindo and six market- strict requirements concerning local ownership, large specific price stabilization teams focused, respectively, numbers of foreign timber companies pulled out of on: 1) Indonesia’s domestic market; 2) the United Indonesia in the late 1970s and early 1980s. At the States and Canada; 3) the United Kingdom and the same time, domestic concession-holders who were European Economic Community; 4) Hong Kong and unable or unwilling to invest in wood processing the People’s Republic of China; 5) Singapore and the operations either sold their timber rights or otherwise 4 At that point, the state forestry enterprises Inhutani I, Inhutani II, and Inhutani III aligned with larger firms. In this way, substantial areas collectively held five concessions covering an aggregate of 3.8 million ha.

24 Table 2.2: Concession Holdings (1994-95) and Plywood Production Capacity (1990) of Indonesia’s 10 Largest Timber Conglomerates

Group Number of Total Area Number of Plywood Capacity HPHs (Ha) Plywood Firms (m3)

______

______Barito Pacific 68 6,125,700 13 1,236,900

______Djajanti 30 3,616,700 6 618,000

______Alas Kusuma 26 3,364,200 5 409,340

______KLI 21 3,053,500 2 349,300

______Bob Hasan Group 12 2,380,800 4 390,000

______Korindo 15 2,225,500 6 624,000

______Surya Dumai 14 1,801,400 3 405,400

______Satya Djaya Raya 13 1,663,500 3 369,000

______Tanjung Raya 15 1,530,500 3 270,500

______Hutrindo 14 1,503,750 3 252,000

______Top 10 Groups 228 27,265,550 48 4,924,440

______Industry Total 585 62,534,370 132 12,595,290

Source: Concession data (Brown 1999); plywood figures (Apkindo 1990).

Middle East; and 6) new markets. Initially, the price to enter into binding sales contracts or to open letters stabilization teams provided market-specific recommen- of credit on their own behalf. Rather, they were obliged dations on a quarterly basis to the marketing commis- to submit proposed sales agreements with prospective sion, which in turn set check prices for Indonesian buyers to the JMB, which would review them to panel shipments to each destination country. determine if the volume of panels, price, and terms In late 1984, Apkindo’s 108 members were of payment were in accordance with the Marketing organized into seven joint marketing boards (JMBs), Commission’s industry-wide policies. In April 1986, the ranging in size from six to 22 firms. With the Ministry Ministry of Trade further authorized the Marketing of Trade’s active support, Apkindo effectively restricted Commission to assign each JMB a quota defining the the allocation of plywood export licenses to members volume of panels that its members were required to of a recognized JMB and, in doing so, established wide- sell to “traditional” markets.5 Producers that either ranging powers over the marketing practices of exceeded or failed to supply the specific volume Indonesian producers. Under the joint marketing sys- assigned to them faced fines of US$100 for every cubic tem, individual panel-makers were no longer permitted meter that they over- or under-sold their quota.

25 Indonesian Exports (‘000 m3) Figure 2.1: Indonesia’s Share of Worls Tropical Plywood Exports, 1980-1997 World Exports (‘000 m3)

14000

12000

10000

8000

6000 Sorce: FAO (various years); Apkindo Sorce: FAO 4000

2000

0 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Year

With the JMB quota system in place, Apkindo those from the transit-processing industries of had the institutional capacity not only to determine the Northeast Asia. price of Indonesian panel exports to each destination As Figure 2.1 shows, Indonesia’s total plywood country but also the ability to micromanage the exports rose from 283,000 m3 in 1980 to just under specific volume of panels that individual producers 9 million m3 in 1991. As significantly, Apkindo’s share shipped to particular markets. Through the mid-1980s, of the world’s tropical plywood exports during this Apkindo’s Marketing Commission used this power to period climbed from 7 to 79 percent. mount strategic assaults on the world’s “traditional” plywood-importing countries, including the United Bob Hasan’s Marketing Monopolies States, Canada, several European nations, China, In his position as chair of the producers’ association, Saudi Arabia, and other parts of the Middle East. It Bob Hasan was able to divert a significant portion of generally did so by flooding these markets with large the plywood industry’s economic rents for his own use volumes of cheap commodity-grade plywood in order (Barr 1998). In one sense, he had unparalleled access to push out competing panel exporters, particularly to hundreds of millions of dollars that were extracted from Apkindo’s members through the collection of a

5 Apkindo used the term “traditional markets” to refer to countries and regions variety of institutional fees, the most significant of that already imported large volumes of tropical plywood in the early 1980s. These which included an export promotion/market develop- included the US and Canada, the United Kingdom and Europe, Hong Kong and 3 China, Singapore, and the Middle East. All other markets were referred to as “new ment fee of US$7-10 per m and an aerial photography markets.” Chris BarrDraft, September 14, 2001 [email protected] fee of US$2-4 per m3. Hasan also used his power

26 within the association to assign monopoly contracts to exports to the Middle East; and Fendi Wood in firms under his own control. In the late 1980s, his Singapore to oversee sales to Singapore and Europe Kencana Freight Lines was awarded an exclusive (Lingga 1994). contract to ship Indonesian panels to foreign markets, With the establishment of these monopoly and his insurance company, PT Tugu Pratama, was distributorships, Hasan’s marketing firms assumed assigned sole authority to insure Apkindo members’ sole authority to engage in negotiations with plywood plywood exports. purchasers and to enter into binding sales contracts. In More significantly, in late 1988, Hasan this manner, the monopoly marketing system stripped established Nippindo, a marketing firm in which he Indonesian plywood producers of virtually all control held a 95 percent interest, to function as the sole over the specific type and grade of plywood they would distributor of Indonesian plywood in the Japanese make; the volume of panels they would produce; the market. Indonesian panel producers were then destination to which these panels would be shipped; required to sell between 15 and 30 percent of their and the price they would obtain for their product. total production through Hasan’s marketing firm at Hasan’s monopolistic marketing strategies prices set by Nippindo. These prices were generally engendered a great deal of resentment among set below market rates, allowing Hasan to capture Apkindo’s member firms, as well as among panel considerable profits through price mark-ups without importers in many destination markets. During the assuming any direct personal risk. By the end of 1993, mid-1990s, South Korean and Japanese buyers, in Nippindo handled 3.4 million m3 in annual panel particular, sought out other sources of plywood shipments to Japan, accounting for 38 percent of whenever this was possible. Many turned to Malaysian Apkindo’s total exports. panel producers, who were then aggressively seeking Through the mid-1980s, Bob Hasan moved to expand their share of the world’s tropical plywood aggressively to expand the monopolistic control that trade. Although the aggregate volume of Indonesian he held over Indonesian plywood exports to Japan by panel shipments to Japan stayed fairly constant introducing similar arrangements for panel shipments between 1992 and 1997, Apkindo was unable to to other destination countries, as well. Specifically, in increase its shipments to that country in spite of the late 1994, he established a series of marketing bodies fact that Japan’s plywood imports grew by 45 percent. which, like Nippindo, were assigned licenses to With Malaysian producers capturing virtually all function as the sole distributor of Indonesian plywood of the additional 1.3 million m3 in Japanese panel to particular national and regional markets. These purchases during that period, Indonesia’s share of the included Indo Kor Panels Ltd. in Hong Kong to handle region’s dominant market fell from 93 to 61 percent sales to the South Korean market; Celandine Co. Ltd. (Apkindo 1998). Similarly, Apkindo’s shipments to in Hong Kong to coordinate panel shipments to China China and Hong Kong fell by 25 percent between 1993 and Taiwan; PT Fendi Indah in Jakarta to manage and 1997, largely in response to sharp growth in

27 China’s domestic wood processing industry. Overall, per year (see Figure 2.2). The paper industry’s real Indonesia’s plywood exports dropped from a peak of production during this period rose correspondingly 9.7 million m3, valued at US$4.6 billion, in 1993 from 826,500 to 5.3 million tonnes (APKI 1997). In to 8.4 million m3, valued at US$3.9 billion, in 1997 1996, 1.2 million tonnes of paper and board products - (Apkindo 1999). or just under one-third of the industry’s total output - were exported. Domestic consumption rose from DIVERSIFICATION INTO PULP 782,420 to 3.1 million tonnes during the decade before AND PAPER PRODUCTION the crisis, reflecting a steady increase in Indonesia’s In the late 1980s, as Indonesia’s wood panel industry per capita paper consumption from 6 kg to 15 kg per was establishing its dominant position in the world’s year (APKI 1997). By 1997, 53 of the nation’s 65 paper tropical plywood trade, the nation’s pulp and paper mills were located in Java, accounting for over 90 industries also entered a period of accelerated percent of the industry’s total production capacity. expansion. Heavy investments in these industries As Table 2.3 indicates, the paper subsector’s during the decade preceding the 1997 financial crisis exponential growth was largely concentrated in three resulted in Indonesia emerging as the world’s ninth- segments of the industry, which collectively accounted largest pulp producer and 13th-leading producer of for 85 percent of total production capacity by 1996. paper and paperboard (Matussek, et al. 1997). These Expansion was most pronounced in the area of investments were motivated, above all, by the fact that industrial paper and board products, due to the the nation’s vast wood supply, which the Suharto increased demand for packaging and shipping government made available to pulp producers with materials through Indonesia’s period of rapid relatively minimal fees, offered producers some of the economic growth (APKI 1997). Annual production lowest output costs in the world (Kenny 1996). In capacity in kraft liner and fluting and in paperboard addition, the extended period of 7-8 percent GDP products both rose by over 750 percent during the growth that Indonesia experienced from the late 1980s decade 1987-1996, reaching 2.0 million and 1.3 million through the onset of the financial crisis generated a tonnes, respectively, before the crisis. Likewise, significant increase in per capita demand for paper and Indonesia’s capacity to produce writing and printing paperboard products among the nation’s population of papers climbed from 329,200 tonnes in 1987 to 1.4 200 million. Investors, moreover, recognized that million tonnes per year in 1996, when it accounted for Indonesian producers were well-placed to take 25 percent of the industry’s potential output. advantage of China’s burgeoning demand for paper By 1997, Indonesia had 10 paper mills with an and board products, which was expected to reach 37.3 annual capacity of 200,000 tonnes or more (see Table million metric tonnes by the year 2003 (Marcus 1994). 2.4). Collectively, these mills were able to generate 4.9 million tonnes of paper and board products per year, Paper and Board Production accounting for 68 percent of the industry’s aggregate Between 1987 and 1997, Indonesia’s aggregate paper capacity (APKI 1997). Five of the nation’s 10 largest and board production capacity expanded by 635 paper mills were controlled by a single conglomerate, percent, climbing from 980,000 to 7.2 million tonnes the Sinar Mas Group, which mounted a series of

28 Figure 2.2: Total Capacity and Real Production of Indonesia’s Paper and Board Industry

6,000,000

5,000,000

Source: APKI 1997. 4,000,000 3,000,000 Capacity Production 2,000,000 1,000,000

0 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 Year

Table 2.3: Growth of Paper and Board Industry by Product Type 1987-1996

Product Type 1987 Production Portion of 1996 Production Portion of Capacity (tonnes/yr.) Industry Total (%) Capacity (tonnes/yr.) Industry Total (%)

______Kraft Liner and Fluting 262,100 27 2,016,300 36 ______Writing and Printing 329,300 34 1,426,100 25 ______Boards 171,400 17 1,346,900 24 ______Newsprint 180,000 18 290,000 5 ______Sack Kraft 0 0 141,500 3 ______Tissue 11,400 1 119,000 2 ______Other 25,800 3 265,400 5 ______Total 980,000 100 5,595,280 100 ______

Source: APKI 1997.

29 Table 2.4: Production Capacity of Indonesia’s 10 Largest Paper Mills, 1997

Firm Business Group Mill Location Production Capacity (tonnes/yr) ______Indah______Kiat (Serang) Sinar Mas West Java 910,000 ______Pindo Deli Sinar Mas West Java 750,000 ______Pakerin n.a. East Java 700,000 ______Tjiwi Kimia Sinar Mas East Java 651,000 ______Fajar Surya Dirgahayu West Java 500,000 ______Aspex Korindo/Hasan West Java 430,000 ______Surya Agung Dirgahayu East Java 336,800 ______Indah Kiat (Riau) Sinar Mas Riau 252,000 ______Lontar Papyrus Sinar Mas Jambi 215,000 ______Jaya Kertas n.a. East Java 200,000 ______Top 10 Mills 4,944,800 ______Other 66 Mills 2,295,630 ______Industry Total 7,230,430

Source: APKI 1997

Figure 2.3: Paper and Board Production Capacity Expansion Planned for 1998-2005 by Province, as of 1997

1,800,000

1,600,000

1,400,000 Source: APKI 1997. New Mills Planned

1,200,000 Expansion by Existing Mills 1,000,000

800,000

600,000

400,000

200,000

0 Province East Riau Irian West Central Jambi Lampung Aceh Java Jaya Java Java 30 takeovers, expansions, and ambitious greenfield production capacity rose by over 650 percent during investments during the 1990s to establish itself the decade preceding the economic crisis, climbing as the dominant player in Indonesia’s paper sector. from 515,000 tonnes per year in 1987 to 3.9 million Altogether, Sinar Mas had nine paper companies in tonnes per year in 1997 (APKI 1997). Real pulp Indonesia in 1997 with a collective production production experienced an annual increase of just capacity of 3.1 million tonnes, giving it direct control under 80 percent per year during this period, rising over 43 percent of the industry’s total output. from 325,000 to 3.1 million tonnes. When the current economic crisis began, the By the onset of the economic crisis in late 1997, rapid expansion of Indonesia’s paper and board 11 of the pulp industry’s 15 mills were directly industry was still in full swing. Indeed, 17 of the integrated with paper production facilities, while four industry’s existing mills had plans to increase their produced pulp for the open market. In contrast to the production capacity by a combined 2.7 million tonnes, paper industry, which is heavily concentrated in Java, most of which was to be installed in East and West over 75 percent of the pulp industry’s capacity is Java (see Figure 2.3). In addition, investors had plans situated in Sumatra. Two pulp mills that accounted to bring 16 new mills online between 1998 and 2005 for 14 percent of total capacity in 1997 are located in with an aggregate capacity of 3.8 million tonnes, Kalimantan, while seven mills accounting for nine mostly in Irian Jaya and Riau (APKI 1997). Twelve of percent of the industry’s production capacity are these new projects were to involve installation of units located in Java. Two of the 15 mills—PT Inti capable of producing 200,000 tonnes or more per Indorayon in North Sumatra and PT Kertas Kraft year. Significantly, much of the planned expansion in Aceh—produce long-fiber pulp from pinewood, while the paper industry was concentrated in the hands of the remaining producers generate short-fiber pulp two business groups: Sinar Mas and the Raja Garuda from a variety of hardwood species. Mas Group. In 1997, Sinar Mas had 4 mill expansion Capital ownership in the pulp industry is even projects scheduled for the following year, which were more concentrated than it is in the paper and paper- intended to raise the group’s aggregate production board subsectors. In 1997, three conglomerates con- capacity by 1.5 million tonnes per year. Indonesia’s trolled approximately 90 percent of the industry’s second-largest pulp producer, Raja Garuda Mas total production capacity. The largest of these is the Group, had seven major paper projects planned at Sinar Mas Group, which owns two giant pulp facilities that point. If fully realized, these expansions would —PT Indah Kiat Pulp & Paper in Riau and PT Lontar have given the group an annual paper production Papyrus in Jambi. Together, these mills were capable capacity of 3.3 million tonnes. of generating 2.0 million tonnes per year, or just over 50 percent of the nation’s overall capacity in 1997. The Pulp Production Raja Garuda Mas Group controls two pulp companies To support Indonesia’s rapidly-expanding paper and - PT Inti Indorayon in North Sumatra and PT Riau board industries, large-scale investments have also Andalan Pulp & Paper in Riau - that are capable of been made in pulp production since the late 1980s. As producing a combined 880,000 tonnes per year. The Figure 2.4 indicates, the nation’s aggregate pulp Bob Hasan Group controlled roughly 17 percent of

31 Indonesia’s pulp capacity in 1997 through PT Kiani processing capacity was planned for East Kalimantan, Kertas, which built the world’s largest greenfield pulp Irian Jaya, and West Kalimantan, with the remaining mill (525,000 tonnes per year) in East Kalimantan in projects spread among other parts of Kalimantan and 1997, and through the Group’s joint partnership with Sumatra. It is likely that some of these projects would the Indonesian government in PT Kertas Kraft Aceh. never have materialized even if the financial crisis had As in the paper industry, plans were in place not occurred. Nonetheless, it is significant that both prior to the onset of the economic crisis for substantial policymakers and industry actors were discussing expansions in Indonesia’s pulp production apparatus. plans to triple the size of Indonesia’s pulp industry In early 1997, the Indonesian Pulp and Paper from 1997 capacity levels over the ensuing eight years. Association reported that two existing mills were seeking to expand their capacity by a combined Pulpwood Plantations 940,000 tonnes in 1998, and that 20 new mills with a The Indonesian government began promoting the collective production capacity of 6.6 million tonnes development of industrial timber plantations (Hutan were slated to be built between 1998 and 2005 (APKI Tanaman Industri, or HTI) in the mid-1980s with the 1997). As Figure 2.5 shows, the bulk of this new pulp stated aim of guaranteeing a long-term supply of raw

Figure 2.4: Total Capacity and Real Production of Indonesia’s Pulp Industry, 1987-1996

3,000,000

2,500,000 Source: APKI 1997 Capacity

2,000,000 Production

1,500,000

1,000,000 500,000

Year 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996

32 Table 2.5: Production Capacity of Indonesia’s Largest Pulp Producers, 1997

Business Group No. of Pulp Mills Production Capacity Portion of (m tonne/yr) Industry Capacity ______Sinar Mas 2 2,000,000 50.8 ______Raja Garuda Mas 2 880,000 22.4 ______Bob Hasan* 2 665,000 16.9 ______Other Producers 9 390,600 9.9 ______Industry Total 15 3,935,600 100.0 ______

* Includes PT Kertas Kraft Aceh, the shares of which are divided between Hasan (15%) and the Indonesian government (85%) Source: APKI, 1997.

materials for the nation’s wood-based industries. In 1992, the Minister of Forestry began According to the Indonesian government’s original designating all areas of production forest located HTI regulations, the Ministry of Forestry would within a 100 kilometer radius of a pulp mill for the allow private investors to establish timber plantations development of pulpwood plantations (Groome Poyry on marginal or degraded forest areas - defined to be 1993). In cases where such areas fell within the those portions of the forest estate holding less than boundaries of an existing timber concession, the HPH- 20 m3 per hectare of commercial species with a holder was instructed to prioritize the clearing of those diameter of 30 cm (Groome Poyry 1993). They were portions needed for the establishment of the HTI. This permitted to manage these areas for a period of 35 allowed pulp projects to circumvent the restriction years beyond the rotation period of the main incorporated into the government’s initial HTI silvicultural species. The New Order state’s HTI regulations against converting natural forests that are program was structured, in particular, to support the still deemed to be productive. In effect, this meant that large-scale investments being made in pulp production. pulp producers were permitted to clearcut areas that Whereas plantations intended to supply timber-based held significant stands of commerciallyvaluable timber industries were limited in area to 60,000ha, HTIs prior to the establishment of their plantations. established to support pulp mills were permitted to Firms establishing pulp plantations in Indonesia be as large as 300,000ha. have generally planted fast-growing hardwood species such as Acacia mangium, Acacia crassicarpa, Gmelina

33 arborea, or Eucalyptus deglupta. With rotation capital investment (Ernst & Young 1999). Firms periods of seven to eight years, these species provide willing to enter into a joint venture with one of the Indonesian pulp producers with a significant competi- Inhutani state forestry enterprises have been able to tive advantage over producers in North America and secure 14 percent of the project’s total costs as a Scandinavia, where pulpwood rotations normally take nonrefundable allocation from the government’s 25 to 35 years. On average, the total cost incurred by Reforestation Fund (Dana Reboisasi, or DR). These Indonesian plantations from the point of opening the firms have also been able to obtain 32.5 percent of the site for planting to harvesting the mature tree crop is investment in the form of a no-interest, noncollater- roughly US$1,000 per hectare (Groome Poyry 1993). alized loan from the DR fund, with a repayment period While this would suggest that HTIs of a substantial of 10 years. Investors have been expected to obtain the size require significant amounts of capital - US$200 remaining 32.5 percent of the necessary capital million, for instance for a project of 200,000 ha—most through commercial loans, which state banks have pulp plantations have been heavily subsidized by the often provided. state. Through mid-1997, the Ministry of Forestry had To provide private investors with an added allocated 23 permits to private investors seeking to financial incentive to establish HTIs, the GOI has establish pulpwood plantations, covering a total area required them to make a direct equity contribution of 4.5 million ha (MoFEC 1999). Thirteen of these equivalent to only 21 percent of the plantation’s total projects, which collectively extend over 3.3 million ha,

Figure 2.5: Pulp Production Capacity Expansion Planned for 1998-2005 by Province, as of 1997

2,000,000

1,800,000 New Mills Planned 1,600,000

Expansion by xisting Mills a Source: APKI 1997 1,400,000

1,200,000

1,000,000

800,000

600,000

400,000

200,000

0 Province Riau Aceh Irian Jaya Jambi Province South Sumatra East Kalimantan West Kalimantan West South Kalimantan 34 Central Kalimantan were designated to be priority investments because Prior to the onset of the financial crisis, there were they were slated to support the pulp industry’s largest strong indications that further expansion of Indonesia’s processing facilities. This designation has allowed pulp and paper and estate crop industries would exert these HTI projects to enjoy a streamlined investment increasingly heavy pressures on the nation’s remaining approval process, under which the Minister of Forestry tracts of natural forest. Between 1987 and 1997, —rather than the Minister of Finance—was able to Indonesia’s pulp and paper industries had each grown allocate financial subsidies from the Reforestation by nearly seven-fold. Before the crisis hit, policymakers Fund. In May 1997, immediately prior to the beginning and investors were discussing plans to carry out of the crisis, only 676,000 ha—or 20 percent of the total further expansions that would triple the production area allocated for priority pulp projects—had been capacities of these industries by 2005. Even if only a planted (MoFEC 1999). At that point, all of Indonesia’s portion these investments were realized, they were pulp mills relied on wood harvested from natural likely to raise the industry’s wood consumption forests for the vast majority of their raw materials. capacity quite substantially from its 1997 level of 16 million m3 per year. The slow pace of plantation Summary development up to that point suggested that much of Through the New Order period, Indonesia’s wood- this wood was likely to come from natural forests. based and estate crop industries have placed heavy pressure on the nation’s forests. Under the HPH system initiated in the late-1960s, the government allocated over 62 million ha of timber concessions to commercial logging companies. Between 1967 and 1997, HPH holders officially harvested approximately 550 million m3 of logs, or just under 20 million m3 per year for 30 years. Unofficial harvests during this period are estimated to have been on roughly the same scale. Following the government’s introduction of a national ban on log exports in 1985, the bulk of this timber has gone to Indonesia’s wood panel industry, which has generated over 70 percent of the world’s tropical plywood exports since the late 1980s. Although the country’s plywood industry had by 1997 entered a period of slow decline, Indonesia’s wood panel producers still consumed roughly 20 million m3 of roundwood per year.

35 Sources Cited Technical Advisory Assistance 1244-INO, Report No. Anderson, Benedict R. O'G. 1990. “Old State, New Society: 1993/108/1, Submitted to the Directorate of Timber Estates, Indonesia's New Order in Comparative Historical Perspective,” Ministry of Indonesia. in B. Anderson, Language and Power: Exploring Political Haughton, Jonathan, Darius Teeter, and Joseph Stern. 1992. “Report Cultures in Indonesia. Ithaca, NY: Cornell University Press. on Forestry Taxation, Private Memorandum, September 8. Apkindo. 1999. "Export of Indonesian Wood Panels.” Kartodihardjo, Hariadi. 1999. “Economic Loss of the State in Unpublished data. Managing Natural Forest.” Unpublished paper Apkindo. 1998. Buletin Apkindo. No. 2, April. prepared for Telapak Indonesia and Environmental Apkindo. 1990. Directory of the Plywood Industry in Indonesia. Investigation Agency, dated August 24. Jakarta: Apkindo. Kenny, Jim. 1996. “Indonesia Aims for a Place at the Top.” Apkindo. 1986. Directory of the Plywood Industry in Indonesia. Pulp and Paper International, August, pp 14-17. Jakarta: Apkindo. Lingga, Vincent. 1994. “Plywood Exports Fall in Wake of Apikindo Tug Asosiasi Pulp dan Kertas Indonesia (APKI). 1997. “Indonesian Pulp of War with Korea.” Jakarta Post October 27, p.5. and Paper Industry 1997 Directory.” PT Gramedia, Jakarta. Lockie, Mark. 1997. “Indonesia Aims to Join the Top 10 Producers.” Barber, Charles V. 1990. “The Legal and Regulatory Framework and Pulp and Paper International, March, pp 18-19. Forest Production in Indonesia.” Appendix to Charles Zerner, MacKinnon, Kathy, Gusti Hatta, Hakimah Halim, and Arthur 'Community Land Rights, Customary Law, and the Law of Mangalik. 1996. The Ecology of Kalimantan. Singapore: Timber Concessions in Indonesia's Forests: Legal Options and Periplus Editions. Alternatives in Designing the Commons.” Forestry Studies Marcus, Amanda. 1994. “Asia: Up for Grabs or Out of Reach for the report UTF/INS/065, Ministry of Forestry/FAO. Jakarta. West?” Pulp and Paper International, February, p. 72. Barber, Charles V. and G. Churchill. 1987. “Land Policy in Irian Jaya: Matussek, Heide, Rita Anna Pappens, Mark Lockie, and Jim Kenny. Issues and Strategies.” Project Report no. INS/83/013. Jakarta: 1997. “Record Run Unbroken as Asia Overtakes European Government of Indonesia; United Nations Development Output.” Pulp and Paper International,July, pp. 20-21. Program: International Bank for Reconstruction and Ministry of Forestry and Estate Crops (MeFEC), 1999. “Perkembagan Development. Pembangunan HTI-Pulp Tahun 1997/1998” Statistik Kehutanan Barr, Christopher. 1999. “Discipline and Accumulate: State Practice Indonesia 1997/1998, Jakarta. and Elite Consolidation in Indonesia's Timber Sector, 1967- Peluso, Nancy. 1992. Rich Forests, Poor People: Resource Control and 1998.” M.Sc. thesis, Cornell University, Ithaca, New York. Resistance in Java. Berkeley: University of California Press. Barr, Christopher. 1998. “Bob Hasan, the Rise of Apkindo, and the Repetto, Robert. 1988. The Forest for the Trees: Government Shifting Dynamics of Control in Indonesia's Timber Sector.” Policies and the Misuse of Forest Resources. Washington, Indonesia, Cornell University Modern Indonesia Project, No. DC: World Resources Institute. 65, pp. 1-36. Ross, Michael L. 2001. Timber Booms and Institutional Breakdown in Brown, David W. 1999. “Addicted to Rent: Corporate and Spatial Southeast Asia. New York: Cambridge University Press. Distribution of Forest Resources in Indonesia; Implications for Ruzicka, I. 1979. “Rent Appropriation in Indonesian Logging: East Forest Sustainability and Government Policy.” DFID/Indonesia- Kalimantan 1972/73 - 1976/77.” Bulletin of Indonesian Economic UK Tropical Forest Management Program, Report No. Studies, Vol. XV, pp. 45-74. PFM/EC/99/06. Sacerdoti, Guy. 1979. “Where Timber is Booty.” Far Eastern Crouch, Harold. 1988. The Army and Politics in Indonesia. Economic Review, November 30, pp. 64-65. Ithaca, NY: Cornell University Press. Sunderlin, William D., Ida Aju Pradnja Resosudarmo, Edy Rianto, and Food and Agriculture Organization (FAO). Various years. Yearbook of Arild Angelsen. 2000. “The Effect of Indonesia's Economic Crisis Forest Products. Rome: FAO. on Small Farmers and Natural Forest Cover in the Outer Fried, Stephanie. 1995. “Writing for Their Lives: Bentian Dayak Islands.” CIFOR Occasional Paper No. 28(E). Bogor, Indonesia: Authors and Indonesian Development Discourse.” Ph.D. Center for International Forestry Research. dissertation, Cornell University. Sunderlin, William D. and Ida Aju Pradnja Resosudarmo. 1996. Rates Gillis, Malcolm. 1988. “Indonesia: Public Policies, Resource and Causes of Deforestation in Indonesia: Towards a Resolution of Management, and the Tropical Forest” in Public Policies and the the Ambiguities. CIFOR Occasional Paper No. 9. Bogor, Misuse of Forest Resources, ed. Robert Repetto and Malcolm Indonesia: Center for International Forestry Research. Gillis. New York: Cambridge University Press, pp. 43-114. Toha, Moch. 2000. “Estimated Deforestation Rate for Indonesia.” Gray, John A. and Hadi Soetrisno. 1989. “Forest Concessions in Unpublished presentation prepared for the CGI Seminar on Indonesia: Institutional Aspects.” Forestry Studies report Indonesian Forestry. Jakarta,January 26, 2000. UTF/INS/065, Ministry of Forestry/FAO. Jakarta. World Bank. 2001. Indonesia: Environment and Natural Groome, Paury. 1993 “Institutional Strengthening for Timber Plantation Resource Management in a Time of Transition. Development, Volume 1, Main Report.” Asian Development Bank Washington, DC: World Bank.

36 Will HPH Reform Lead to Sustainable Forest Management?: Questioning the Assumptions of the “Sustainable Logging” Paradigm in Indonesia

Chapter 3 Since the mid-1980s, policy discussions aimed at increase in the government’s timber royalties and fees promoting sustainable forest management in Indonesia to halt the flow of resource rents - that is, revenues have focused almost exclusively on reforming the HPH above a ‘normal’ rate of return - to concession-holders timber concession system. This emphasis on HPH (Brown 1999; Scotland and Whiteman 1997; World reform is hardly surprising given the pressures that Bank 1993; Ingram 1989; Gillis 1988). From a fiscal Indonesia’s commercial logging industry has put on perspective, they maintain that the government’s the nation’s forests over the last three decades. From failure to fully capture timber rents implies the loss of 1967, when the New Order regime opened the rich funds that might otherwise be used by the state for dipterocarp forests of the Outer Islands to large-scale formal budgetary allocations. In terms of sustainability, timber extraction, the Indonesian government has they argue that access to excessive profits leads allocated a total of 585 HPHs, covering 62 million ha, concession-holders to undervalue the resources under to private and state-owned logging companies (Brown their control, which effectively undermines their 1999). According to official figures, HPH-holders incentive to manage their HPHs sustainably over the generated 612 million m3 of roundwood between 1970 long term. and 1999, or 20.4 million m3 annually for 30 years. Third, policy analysts have long called on the Some industry analysts have argued that actual timber Indonesian government to lift the prohibitive removals by HPH holders during this period were, in restrictions on log exports that it has maintained since fact, approximately twice this volume (Kartodihardjo the early 1980s (Manurung and Buongiorno 1997; 1999). World Bank 1995; Vincent 1992; Lindsay 1989). They Policy analysts advocating reform of the HPH emphasize that these restrictions have led concession- system as a means to achieve sustainable forest holders to sell virtually all of the timber they produce management have generally prioritized three to Indonesia’s wood processing industries at prices that objectives. First, they have sought to increase the are well below international market rates. Underpricing government’s capacity to enforce the technical aspects of this sort is believed to promote inefficiency both at of sustainable concession management (Ministry of the point of log harvesting and during processing Forestry 1995; World Bank 1993; Gray and Hadi 1989). operations. In practice, such efforts have largely been oriented Taken together, these three sets of prescriptions - toward designing more effective mechanisms for selective cutting, full rent capture, and market-based monitoring concessionaires’ harvesting practices in efficiency—represent the essential pillars of what can order to ensure that they adhere to the selective be called the “sustainable logging” paradigm. While cutting guidelines stipulated in the HPH contract.1 the policy prescriptions associated with this paradigm Second, forest economists have advocated a sharp have been proposed, in some form, for practically every timber-producing country in the world, they 1 Key elements of the Indonesian Selective Logging and Planting (Tebang Pilih Tanam Indonesia, or TPTI) guidelines include the use of a 35-year harvesting cycle; restrictions have been advocated especially loudly in the case of on cutting commercial species that are below 50 cm in diameter at breast height(dbh); Indonesia. This approach to sustainability has been rehabilitation of skid trails and enrichment planting; and thinning of non-commercial articulated most recently and most comprehensively by species at 10, 15, and 20 years. Djamaludin (1989) provides a detailed account of the development and implementation of the TPTI guidelines during the 1970s and 1980s. the World Bank following the onset of the current

37 economic crisis in late 1997. Key elements of the This chapter examines each of these assumption and the Bank’s reform proposals included the following policy policy prescriptions that emerge from them. Based on this interventions: analysis, it is argued that the “sustainable logging” reform ______agenda is quite unlikely to succeed in reducing Indo- strengthening HPH contracts by extending them to nesia’s timber harvests to the government’s own widely 35 years and making them transferable; ______cited sustainability threshold of 25 million m3 per year.2 enforcing improved concession management by Indeed, for structural reasons this may, in fact, be an introducing performance bonds and unachievable goal. Reform of the HPH system alone fails independent monitoring; to address key factors that are encouraging unsustainable ______rates of log removals— most notably, effective demand for removing market-distorting practices by lifting timber on the part of the nation’s wood processing restrictions on logs, sawnwood, and wood panels; industries and new technologies that have made previ- ______ously marginal areas and species commercially viable. increasing the state’s rent capture by raising The reforms of the HPH system proposed by the World timber royalties and introducing area-based fees Bank and others have also failed to address significant for logging concessions (World Bank 1998). ______qualitative changes that have occurred in the sources of

Five basic assumptions have supported efforts by timber supply over the past decade. These include a the World Bank and others to achieve sustainable marked decline in the volume of logs generated by management of Indonesia’s forests by reforming the concession-holders, as well as a corresponding rise in HPH system. These include the following: large-scale forest conversion and other unsustainable harvesting practices. Moreover, in assuming that sustainable 1) Controlling log supply, without taking any direct concession management is profitable, proponents of the steps to reduce demand for industrial timber, is an “sustainable logging” paradigm erroneously conclude that effective strategy for sustaining the nation’s natural most private timber operators will be willing—over both forest resource base. the short and long term—to employ environmentally 2) The most effective means of reducing Indonesia’s sustainable logging practices if required to do so. Finally, log harvests to a sustainable level is by reforming advocates of HPH reform as a strategy for achieving the HPH system. sustainability generally overestimate the Indonesian government’s political will to impose a substantial 3) Increased efficiency will promote the conservation of reduction in the nation’s timber supply, as well as its natural forests. institutional capacity to carry out such a policy. 4) Sustainable concession management is profitable.

5) The Indonesian government has the institutional 2 For the purposes of this paper, I do not examine how this figure was derived, nor do I analyze whether it, in fact, represents a realistic estimate of the volume capacity to enforce the proposed changes in the of wood that can be sustainably harvested from Indonesia’s natural forests. HPH system and the forest products trade. Rather, I maintain that even if this figure is assumed to be a reasonably accurate estimation of the nation’s sustainability threshold, it is doubtful that the HPH reforms advocated by proponents of the “sustainable logging” paradigm will effectively reduce timber removals to this level.

38 ASSUMPTION #1: Controlling log supply, without the forests under their control, the Bank has called taking any direct steps to reduce demand for for the Indonesian government to extend the HPH industrial timber, is an effective strategy for contract from 20 to 35 years and to make concessions sustaining the nation’s natural forest resource base. transferable. Collectively, these policy interventions have been A central objective for advocates of the “sustainable intended to introduce more effective mechanisms for 1 restricting the volumes of logs that are harvested from logging” paradigm has been to establish tighter controls over Indonesia’s timber supply in order to areas managed by timber concession-holders. To the reduce log removals to the supposedly sustainable extent that the World Bank and proponents of HPH level of 25 million m3 per year. Since the late 1980s, reform have addressed the issue of demand for logs on the World Bank has sought to accomplish this by the part of wood processing industries, they have done persuading the Indonesian government to enforce so only indirectly. Their attention to industrial timber improved HPH management practices through the demand has generally been limited to advocating implementation of performance bonds and an policies designed to push Indonesia’s wood processors independent monitoring system (World Bank 1993; to invest in efficiency, which will presumably lead these 1998). Moreover, to give logging companies an processors to reduce the overall volume of wood they economic incentive to adhere to the government’s consume. In seeking to remove restrictions on log selective cutting guidelines and to reduce damage to exports and to raise timber royalties, for example, the

Table 1: Production Capacity and Roundwood Consumption of Indonesia’s Major Wood-Based Industries, 19973

Industry Units Production Estimated Real Est’d Roundwood Capacity Production Consumption (m3) ______Sawnwood and 3 3 Moulding______2,345 18,975,000 m 13,300,000 m 24,180,000 3 3 Plywood______115 12,600,000 m 10,080,000 m 20,160,000

______Pulp 15 3,900,000 tonnes 3,400,000 tonnes 16,660,000

______Total 61,000,000

Sources: Indonesian Sawmillers Association (ISA); Apkindo; and APKI

3 Production capacity figures included in this table are based on statistics provided to have had an average recovery rate of 50 percent. by the respective industries’ producers associations. However, several assumptions are Pulp producers are estimated to have operated at 87 3 made to estimate real production levels and roundwood consumption. In the aggregate, percent of installed capacity, with 4.9 m of roundwood sawnwood and moulding producers are estimated to have operated at 70 percent of needed to produce each tonne of pulp. their installed production capacity, and to have had an average recovery rate of 55 percent for the roundwood they consume. Plywood producers are estimated to have operated at 80 percent of their installed capacity, and

39 World Bank has sought to bring Indonesia’s domestic plywood is too important for the economy. The log prices up to international parity levels. Their pri- Forestry Department will always find a way to make mary aim in doing so has been to force the country’s more timber available, as long as the demand exists. plywood and sawmills to use fewer logs in generating In fact, this is what they have done over the last their processed wood outputs. several years in opening large areas of IPK By focusing almost exclusively on controlling [conversion forest], carrying out the One Million timber supply rather than reducing effective demand Hectare Peatlands Project, and so forth.”5 for logs, advocates of the “sustainable logging” para- Policymakers are likely to feel particularly strong digm have essentially failed to recognize the degree to pressures to ensure a continuous supply of raw which overcapacity exists within Indonesia’s wood- materials to industries, such as pulp and paper, in based industries and the structural problems that it which processing facilities entail extremely high fixed poses. In fact, the installed production capacities of the costs and/or in which processors have close ties to nation’s sawnwood, plywood, and pulp industries have state elites. created a demand for logs and fiber that substantially The structural demand for substantial volumes of exceeds the supply capacity of Indonesia’s formal timber above and beyond those generated by the timber production apparatus. Table 1 shows the official log supply is a central factor driving Indonesia’s installed production and wood utilization capacities illegal timber trade. Estimates of illegal log removals of these three industries in 1997. in recent years have ranged from 12 to 32 million m3 While aggregate roundwood consumption capacity per year (ITFMP 1999). There is anecdotal evidence for the three industries stood at approximately 78 suggesting that illegal logging may have expanded million m3 during 1997, it is conservatively estimated dramatically in many parts of the country since the that these three industries consumed 61 million m3 financial crisis began. Undocumented harvesting is of raw materials.4 This figure is 36 million m3 higher often carried out by licensed concession-holders who than the volume of timber removals that the Minstry extract logs above their annual allowable cut or by of Forestry and Estate Crops claims is sustainable as logging in areas that have not been approved by the an annual harvest. Ministry of Forestry (Kartodihardjo 1999). At times, The existence of such a substantial “structural this includes forests located outside their concessions. timber deficit” poses fundamental problems for the Moreover, organized syndicates of illegal loggers are “sustainable logging” reform agenda in terms of both known to be active in most timber-producing policy formulation and implementation. On the one provinces (Telapak Indonesia and EIA 1999). While hand, the very existence of these industries promotes these groups are often financed by local an expectation among policymakers that processors businesspeople—in some cases HPH-holders—they should have access to raw materials--that is, that they are said to almost always involve some degree of are literally machines that need to be fed. As a collusion with members of the armed forces, the local plywood officer at the Barito Pacific Group explained 4 By comparison, Scotland, et al. (1999) estimate that in 1997, aggregate real in an interview, “The government won’t let the consumption of roundwood in Indonesia may have been as high as 82.3 million m3. industry collapse from lack of raw materials because 5 Interview with Soedibyo, director of Barito Pacific Group, February 19, 1999.

40 forestry bureaucracy, and other elements of the through the introduction of performance bonds and government’s law enforcement apparatus. In parts of independent monitoring; extending the HPH contract Kalimantan and Sumatra, whole units of the armed and making it transferable; de-linking HPHs and pro- forces and national police are known to run rogue cessing facilities; and raising the state’s rent capture by timber operations as a means of supplementing their increasing timber royalties and introducing area-based official budgets (Asnawie 2000; WWF and DFID 1998; fees. By contrast, proposed reforms have directed Sacerdoti 1979). scant attention toward reducing log output levels from The pervasiveness of illegal logging and the other (i.e. non-HPH) legal sources of timber production Indonesian government’s relatively weak capacity to or toward controlling illegal log removals outside of enforce its own forest boundaries suggests that any HPH areas. efforts to control timber supply without reducing This emphasis on reforming the HPH system made effective demand on the part of the nation’s wood- a fair amount of sense in the late-1980s when Indo- based industries is likely to be futile. Indeed, wide- nesia’s timber concessions formally generated between spread sentiment within the industry suggests that the 26 and 27 million m3 of logs per year, accounting for establishment of an effective log monitoring and regul- approximately 90 percent of the country’s official atory system would take several years to implement, timber supply (Departemen Kehutanan 1994). Over the even under the most favorable of circumstances. last decade, however, Indonesia’s legal timber supply Continued demand for illegal timber on the scale that has experienced significant changes that recent policy currently exists in Indonesia is likely to seriously proposals aimed at promoting “sustainable logging” undermine this process and to keep log removals well have largely failed to address. Specifically, there has above the government’s own sustainability targets. In been a steady decline in the volume of logs officially this way, it would appear that any serious attempt to cut produced within the HPH system since 1990. harvest levels substantially must, at some point, involve According to Ministry of Forestry statistics, timber proactive steps to reduce production capacity on the production levels realized under concessionaires’ part of Indonesia’s wood processing industries. approved annual workplans (Rencana Karya Tahunan, or RKT)—in effect, the cumulative legal output for all ASSUMPTION #2: The most effective means of HPH-holders—dropped from just under 24 million m3 restricting Indonesia’s log harvests to a sustainable in 1990-91 to 15 million m3 in 1996-97 (Direktorat Bina level is by reforming the HPH system. Pengusahaan Hutan 1999a). This 37.5 percent drop in RKT output at the national level was, in fact, surpassed A majority of the forestry sector policy interventions by the declines recorded for many of Indonesia’s major put forth by the World Bank and other proponents of timber-producing provinces. RKT levels during this the “sustainable logging” paradigm have focused on period dropped by 48 percent (from 6.0 to 3.2 million 2 3 reforming the HPH system in order to bring about a m ) in East Kalimantan and by 79 percent (from 2.9 sharp reduction in timber production levels. Proposed million to 600,000 m3) in Riau. interventions to the HPH system have included better This sharp decline in RKT production levels stems enforcement of concession management practices from the fact that large numbers of HPHs were taken

41 out of production during the 1990s. Indeed, by the the province’s RKT output levels rose from 732,000 m3 time President Suharto was forced to step down in in 1990-91 to 2.3 million m3 in 1997-98, in sharp mid-1998, only 389 of the 652 concessions that had contrast to the declines recorded in most other timber- been distributed during the New Order period producing provinces (Direktorat Bina Pengusahaan remained in operation.6 Seventy-seven HPHs covering Hutan 1999a). 5.5 million hectares were either returned to the state During this period, the Ministry has also taken or revoked by the Ministry of Forestry before the steps to broaden and deepen the nation’s legal timber concessionaire’s initial 20-year contract had ended. production system in order to generate significant More significantly, the Ministry chose not to renew volumes of logs from new sources. It has done so by: the license for 186 HPHs covering 15.7 million 1) Slating large areas of forest for conversion to other hectares after their initial contract period had expired. uses, and making these available to logging Unfortunately, detailed information on why these companies for clear-cutting; HPHs were revoked or not extended is not publicly available, so it is difficult even to speculate on the 2) Allowing private timber operators to extract logs extent to which these areas remain at all commercially from areas under Inhutani control through ad hoc viable. Of the 263 HPHs that reverted to the state, only contractual arrangements; 33 covering 3.3 million hectares were reallocated to 3) Weakening of the HPH system’s Indonesian other concession-holders. A far larger number--147 Selective Logging and Planting (Tebang Pilih HPHs covering 9.5 million hectares--were assigned to Tanam Indonesia, or TPTI) selective the control of the state’s five Inhutani forest cutting guidelines. enterprises for ‘rehabilitation.’ Over the past several years, the Ministry of Although each of these strategies poses direct Forestry has adopted a number of strategies to make challenges to the sustainability of natural forests, they new supplies of timber available to Indonesia’s wood- have thus far largely gone unaddressed by those based industries to compensate for the HPH system’s advocating policy interventions aimed at promoting declining output. Within the parameters of the HPH “sustainable logging” through HPH reform. system, the Ministry has responded to the growing scarcity of accessible and commercially valuable logs Growing Reliance on Forest Conversion in many parts of Kalimantan and Sumatra by opening The most significant strategy Ministry of Forestry has the expansive forests of Irian Jaya (now referred to as used for maintaining Indonesia’s formal timber supply Papua) to large-scale logging. It has done so by allocat- has been to make vast tracts of conversion forest ing 40 HPHs in Papua, covering an area of 9.7 million available to logging companies for clear-cutting. Since ha, between 1989 and 1997 (Direktorat Penyiapan the early 1990s, this policy has been tied to the Pengusahaan Hutan 1998). Papua’s role as the timber government’s efforts to support the development of industry’s new frontier is made clear by the fact that the nation’s pulp and oil palm industries by opening up forested areas for the establishment of tree plantations. 6 The figures in this paragraph are drawn from Ministry of Forestry data (Kartodihardjo and Supriono 1999). Under the Ministry’s forest conversion policy, a private

42 timber operator is able to obtain a Wood Utilization posed by widespread conversion of natural forests Permit (Izin Pemanfaatan Kayu, or IPK) to harvest the calling it “one of the most insidious forces operating in timber from areas that have been slated for conversion. the forests at present in Indonesia” (World Bank 1998, In contrast to the HPH contract, the IPK agreement 16). Significantly, however, the Bank fails to recognize allows the logging company to employ nonselective the degree to which the government’s conversion harvesting techniques and to pay minimal royalties policy is linked to the aggregate decline in timber (and no reforestation fee) on the logs that are cut. yields from the HPH system over the last several years. Although some of Indonesia’s timber groups have In fact, it identifies “the most significant forces for made investments in oil palm plantations, it is not un- conversion of forest” as being largely exogenous to common for IPK-holders to abandon these sites once the forestry sector per se: oil palm and cocoa projects; they have removed all stems of commercial value. livelihood-based agriculture; and transmigration As Figure 1 shows, the aggregate volume of timber (World Bank 1998, 16). This leads the Bank to offer the produced through IPK forest conversion rose from astonishing conclusion that “most of the conversion 4.2 million m3 in 1994-95 to 10.1 million m3 in 1997-98, pressures on the forests in recent years in Indonesia compensating substantially for the sharp decline in have originated from decisions made by stake holders logs produced under the HPH system (Direktorat and interest groups outside the official Ministry of Bina Pengusahaan Hutan 1999b). Forestry.” In its 1998 issues paper, the World Bank The Bank’s failure to appreciate the central role that acknowledges the very major threat to sustainability forest conversion currently plays in MOFEC’s

Figure 1: Roundwood Production from RTK vs IPK

20,000,000

18,000,000

16,000,000 IPK 14,000,000 RTK 12,000,000

10,000,000

8,000,000

6,000,000

4,000,000

2,000,000

Volume 1994/95 1995/96 1996/97 1997/98 Year

Source: Ministry of Forestry, Direktorat Bina Pengusahaan Hutan 1999b.

43 roundwood supply strategy leads it to grossly under- degraded areas, to cut in logged-over areas before estimate the pressures that exist both within the their 35-year rotation has passed, and to engage in a private sector and within the state to keep a large-scale variety of other practices that technically would not be conversion policy in place. Given the fact that IPK allowed under a HPH contract. Indeed, Titus Sarijanto, forest conversion accounts for roughly 40 percent of former Director General of Forest Production, the nation’s legal timber and pulpwood supply, it is acknowledged in an interview that it is not unusual for difficult to imagine that the ministry will not seek to the Inhutani enterprises to permit private timber maintain current conversion levels for as long as possi- operators to log in areas classified as rehabilitation ble to meet the demand for timber among Indonesia’s forest. As he explained: wood-based industries. Moreover, now that estate This occurs for two reasons: Often an area needs to be crops are formally under the ministry’s jurisdiction, cleared before it can be rehabilitated. Sometimes, too, it can promote large-scale forest conversion without the Inhutanis don’t have the funds to carry out the losing administrative authority over the areas allocated rehabilitation, so they will allow a portion of the area for agroindustrial estates. to be logged in order to finance the rehabilitation of the rest.8 Exploitation of Areas Under Inhutani Control A second strategy employed by Ministry of Forestry A senior officer at Inhutani I in East Kalimantan also has been to allow select logging companies to extract stated that “to ensure security of these areas, Inhutani timber from areas that are under the jurisdiction of the needs to have activity there. If we don’t log in these Inhutani state forestry enterprises, which currently areas, it is certain that other parties will come in and totals just under 10 million ha.7 This typically occurs in take whatever wood is left.”9 one of two ways: In some cases, the ministry allocates Some industry observers suggest that one of the an area with remaining stands of commercially Inhutanis’ motives for exploiting the forests under valuable timber as an HPH that is run as a joint ven- their jurisdiction is that the funds generated play an ture between a private timber operator and one of the important role in supporting the Forestry Inhutanis. More often, an Inhutani will engage a Department’s formal and informal budgetary needs private logging company—at times, reportedly, an (Ascher 1998). Moreover, it is widely believed that the area’s former concession-holder—to harvest timber individual Inhutani enterprises have a significant stocks under an informal work contract known within degree of discretion in deciding which logging the industry as KSO (kerja sama operasi, or companies will have access to KSO contracts, which operational collaboration). 7 There are currently five Inhutani state-owned forestry enterprises. PT Inhutani I controls There exists little public information about the 3.9 million ha in East Kalimantan, South, Central and terms of these contracts, the types of areas exploited, North Sulawesi, and Maluku. PT Inhutani II controls 3.8 million ha in South, East, and West Kalimantan and Central Sulawesi; PT Inhutani III controls 2.9 million ha in South, and the management practices used or the volumes of Central and West Kalimantan; PT Inhutani IV controls 500,000 ha in North Sumatra, logs produced under such arrangements. However, West Sumatra, Aceh, and Riau; and PT Inhutani V controls 400,000 ha in South many industry observers claim that KSO contracts Sumatra, Jambi, Bengkulu, and Lampung. 8 Interview with Titus Sarijanto, Jakarta May 3, 1999. often enable logging companies to harvest timber from 9 Confidential interview, Inhutani I, Tarakan, East Kalimantan, March 25, 2000.

44 areas will be opened to timber operations, and what under TPTI. Some industry observers have also types of harvesting practices will be permitted.10 Many speculated that the introduction of the TPTJ system of these decisions, which play a critical role in may, in fact, be the Ministry of Forestry’s first step in determining whether sustainable harvesting practices opening logged-over areas to commercial timber are used, are apparently made by Inhutani field officers extraction without regard to where those forests are in and the contractors working with them. the 35-year rotation originally designated under the HPH contract. Weakening of Selective Cutting Guidelines Finally, the Ministry of Forestry has sought to bolster ASSUMPTION #3: Increased efficiency will the output from Indonesia’s remaining HPHs by promote the conservation of natural forests. modifying the principles of the TPTI system. It has done so most significantly by introducing a new Proponents of the “sustainable logging” paradigm silvicultural system, Selective Logging and Line have long argued that raising efficiency levels in all Planting (Tebang Pilih Tanaman Jarak, or TPTJ), in segments of the timber sector is a critical component in November 1998. The TPTJ guidelines may be applied any strategy for conserving Indonesia’s natural forests. on areas of production forest with a slope no greater In a 1995 study on the economics of long-term forest than 25 percent and with altitudes up to 500 meters management in Indonesia, the World Bank, for above sea level.11 Ostensibly designed as a modification instance, argues that “sustainability should be sought of the TPTI system to make it more appropriate for through the promotion3 of efficiency, rather than an logged-over areas, the TPTJ scheme may also be attempt to simply administer a reduced flow of raw applied to tracts of primary forest as well. materials to the sector, while leaving cost and price Under the TPTJ system, the timber operator is conditions and incentives unchanged” (World Bank permitted, first, to carry out selective logging of a 1995, 16). The Bank and others calling for increased designated block using a 40 cm maximum diameter efficiency in the timber sector have generally cutting limit. This initial harvest is followed by the use addressed the issue in both allocative and operational of clear-cutting to open up “planting strips,” which are terms. Whereas allocative efficiency refers to who then to be planted with high-value local species. By produces and where, operational efficiency is con- reducing the cutting limit from the 50 cm diameter cerned with how efficiently each producer conducts prescribed under the TPTI guidelines and by its activities. permitting a portion of the area to be clear-cut, TPTJ Proponents of the “sustainable logging” paradigm will make substantially larger volumes of logs available seek to raise the sector’s allocative efficiency to from a given area of forest than would be possible promote the optimal distribution of the nation’s timber resources in accordance with market-based 10 Personal communication, Hariadi Kartodihardjo, Bagor, February 10, 1999 and Mubariq Ahmad, Jakarta May 4,1999. calculations of cost and scarcity. To the extent that 11 The TPTJ system is specified in Keputusan Menteri Kehutanan No 435/Kpts-II/97 efficient producers receive a larger share of the and No. 338/Kpts-II/1998, and in Keputusan Menteri Kehutanan dan Perkebunanan nation’s timber output, the sector’s overall efficiency is No. 625/Kpts-II/1998. A critical examination of the implications of the TPTJ system is provided by Purnama, et al. (1999). expected to improve. At the same time, they promote

45 an increase in operational efficiency for individual obtain full market value for their logs (Manurung and producers through a reduction of waste in timber Buongiorno 1997; Barbier, et al. 1995; World Bank harvesting and higher log utilization rates in process- 1995; Vincent 1992; Lindsay 1989). They claim that ing. The rationale is that even if the same producers policies that have kept domestic timber prices below account for the same share of total production, any international parity levels have led processing increase in efficiency will reduce pressure on forests. companies to use their wood inputs carelessly. This, Most proponents of the “sustainable logging” para- in turn, has kept the volume of timber being logged digm consider the two types of efficiency to be closely higher than would have been necessary if wood panel linked. Policy interventions that raise allocative producers and sawmills were able to generate their efficiency within the timber sector are generally processed wood products in a more efficient manner. deemed to be a crucial mechanism for increasing These analysts argue that higher log prices will operational efficiency on the part of timber producers promote the sustainability of Indonesia’s natural and wood processors. forests in two ways: First, increased profits from To raise allocative efficiency in the timber sector, timber sales should lead concession-holders to attach the World Bank has long sought to remove several of greater value to the forest resources under their the major market-distorting policies put in place by the control, and in doing so, to take steps to reduce the New Order state. Since the current economic crisis volume of waste associated with their harvesting began, it has taken steps to lift restrictions on log and operations. Second, substantially higher raw material sawnwood exports; to eliminate controls over plywood costs are likely to lead Indonesia’s wood-based marketing held by Apkindo; to de-link logging conces- industries to invest in more efficient processing sions and processing facilities; and to make HPHs techniques, which will presumably generate greater transferable. The Bank justifies these reforms by levels of output with a smaller volume of logs. arguing that the government’s restrictive policies have In their efforts to raise domestic log prices, the led to an uncompetitive and inefficient processing World Bank and other advocates of efficiency-based sector, “characterized by high levels of rent-seeking, sustainability have largely ignored the additional which has become totally dependent on highly pressures that the removal of log export restrictions subsidized log prices” (World Bank 1995, 16). The would place on Indonesia’s forests. Nonetheless, it Bank maintains that the log export ban, in particular, is probable that open access to international timber has undermined sustainability by leading “the sector markets—where roundwood prices are often [to] substitute logs, which should be regarded as a considerably higher than they are domestically— scarce factor of production for other factors... would introduce a substantially greater structural [encouraging the forests to be] treated as a low-value demand for Indonesian logs than currently exists. resource by both the private sector and government Such additional demand on the part of foreign buyers agencies” (World Bank 1995, 16). can be expected to create pressures for increased In calling for the removal of log export restrictions, levels of timber removals in both Indonesia’s legal and the World Bank and others have maintained that they illegal logging industries, leading to large volumes of are seeking to enable Indonesian timber producers to roundwood being shipped overseas. The correlation

46 between reduced export taxes and increased logging producers have, in fact, purchased a growing portion is, in fact, predicted by most econometric studies that of their logs from outside their own concessions. have analyzed the marketing restrictions imposed in The Barito Pacific Group, Indonesia’s largest panel Indonesia’s timber sector over the last 20 years (cf producer, has reportedly purchased 30 to 40 percent of Manurung and Buongiorno, 1997; Barbier, et al. 1995). its logs since 1994.12 Similarly, the Korindo Group is Together with the World Bank, however, these analy- reported to purchase over one-half of the 1.3 million ses generally assume that pressures for additional m3 that its mills consume, due to the declining logging will be offset by steps taken to raise efficiency productivity of its own concessions and the fact that on the part of wood processors. Unfortunately, none of several of its own HPHs have been involuntarily these studies provides compelling evidence to support revoked.13 Several industry officers interviewed in the this assumption. course of this study indicated that their firms often The effects of such pressures to increase log supply have little information on either the source of these will be particularly acute if Indonesia’s log export logs or the conditions under which they are harvested. restrictions are removed before effective mechanisms As one plywood executive put it: are installed to control timber extraction and market- We buy logs from a broker. Sometimes they have ing. In the absence of such controls, higher log prices documentation, but often they do not. We generally do are likely to support a proliferation of illegal logging not know where the logs come from. If the Forestry above the current high levels that exist in most timber- Department finds out that we’re using logs without producing provinces. A similar problem arises with the documentation, we point to the broker and he’s the World Bank’s proposal to de-link HPHs from process- one that gets penalized.14 ing facilities. The Bank’s rationale for trying to separate the two is that it will “weaken the official The World Bank and others seeking to deregulate monopoly over log supplies that large-scale processing Indonesia’s timber trade have done so to encourage complexes have hitherto benefited from” (World Bank both concession-holders and wood processors to invest 1998:20) and, in doing so, remove a major structural in measures that will improve the efficiency of their factor contributing to the undervaluing of Indonesian operations. Investments in harvesting efficiency might forests. The Bank envisions the development of a include the use of new technologies or practices that domestic log market, in which processors would be allow logging companies to extract more timber from forced to purchase the bulk of their raw materials at each hectare of forest, more wood out of each stem market rates (which would presumably be on par with that is cut, or larger volumes of timber harvested in international prices if log export restrictions were shorter time frames or at reduced cost. Similarly, successfully removed). As with opening log exports, measures to raise processing efficiency would include however, the Bank’s efforts to de-link HPHs and mills the adoption of new equipment or techniques that are likely to encourage an expansion of illegal logging if they are carried out before an effective chain of 12Interview with Soedibyo, director of Barito Pacific Group, February 19, 1999. custody system is put in place. 13 Interview with Kim Young Cheol, manager of Forestry Division, Over the past several years, many Indonesian panel Korindo Group, February 25, 1999. 14 Confidential interview, Jakarta, February 9, 1999.

47 enable wood processors to raise the volume and/or would generally leave a 15-25 cm core that could not value of output from each unit of wood that their mills be peeled. According to several producers interviewed, consume. the use of the new technology has had the practical The arguments used to promote greater operational effect of raising their log recovery rates—particularly efficiency are rooted in the assumption that improve- when their preexisting machinery had become highly ments in efficiency at both the harvesting and depreciated—from the 45 to 50 percent range to that of processing levels will relieve pressures on Indonesia’s 55 to 60 percent. forests. Embedded in this assumption is a belief that if As significantly, the new rotaries have enabled firms are able to obtain greater output from each cubic producers both to peel logs from younger trees and meter of wood (or hectare of forest) by improving the to process a variety of timber species that were efficiency of their operations, they will thereafter previously considered to be marginal. In this sense, demand the same or possibly a smaller volume of the widespread adoption of the new rotaries is likely timber (or exploit a smaller area). Efficiency becomes to increase the burden on Indonesia’s forest resource associated with conservation because it is assumed base quite substantially. Indeed, several producers that investments in efficiency will produce greater interviewed for this study indicated that the new volumes of processed output without generating rotaries had given them incentive to return to logged- increased demand for raw materials. Yet, there is little over areas for a second harvest and/or to seek evidence to indicate that either logging companies or harvesting rights in areas without old-growth diptero- processing firms would voluntarily place a cap on their carps. Most admitted that both of these processes earnings by restricting the volume of timber they would have been uneconomical just a few years ago, harvest or process, if access to this timber were not when their mills’ capabilities were limited by the otherwise constrained. On the contrary, basic econom- constraints of the large-spindle peelers that were then ic theory would suggest that firms able to raise profits in place. As a timber manager with the Korindo Group through increased efficiency would have an incentive explained, “The new rotaries are what has made IPK to expand their operations, thereby increasing their profitable, as we can cut trees with diameters of 20 cm demand for logs. and up and all species but ulin and bengeris. With the Moreover, technological innovations, such as the old technology, we would not have been able to use widespread adoption of the chainsaw, that increase most of this for plywood.”17 efficiency in timber extraction or processing have, at 15 Colfer (1983), for instance, describes a rapid acceleration in timber harvesting in times, changed the nature of demand and/or the Apo Kayan region of East Kalimantan following the introduction of the chainsaw in the late 1970s and early 1980s. accelerated the pace of forest destruction quite 16 The new rotaries cost between US$1 million and US$2 million, and as such, they considerably.15 The growing adoption of small-spindle are a form of technology that is accessible (though by no means inexpensive) to rotaries on the part of Indonesian plywood producers plywood producers of all sizes. Indeed, 12 of the 15 firms interviewed indicated that they had either already installed or initiated the purchase of new rotaries in at least may be having just such an effect.16 Introduced in the one of their mills. For many producers, the installation of the new rotary has been part mid-1990s, the new rotaries allow panel producers to of broader restructuring process, which has often involved the purchase of new driers, kilns, and hot presses, as well as other capital investments to improve efficiency. The peel logs as small as 15 cm in diameter, leaving a core general belief within the industry is that all of Indonesia’s plywood producers will of 6-8 cm. The old, large-spindle rotaries, by contrast, eventually buy new rotaries, although many will now have to wait until after the economic crisis is over to do so.

48 concession-holders to capture no less than 83 percent ASSUMPTION #4: Sustainable concession of the rents generated in the timber sector during the management is profitable. period 1980-90, or roughly US$80 in rent for every cubic meter these companies harvested. Beyond seeking to rescind Indonesia’s log export Several concessionaires contacted in the course of restrictions, the World Bank and other proponents of this study, however, indicated that the profitability of the “sustainable logging” paradigm have called on the timber extraction on at least some of their HPHs had government to raise timber royalties and to introduce a declined markedly over the past decade. Some system of performance bonds to ensure that logging attributed this to the fact that the most productive parts companies manage their concessions sustainably. of their concessions—particularly those areas with Implicit in these proposals is an assumption that HPH- stocks of high-value, high-diameter meranti (Shorea holders will be able to4 generate profits in spite of the spp.)—have already been logged over, and they are additional costs that these new fees impose on their now harvesting stands of lesser commercial value. operations. That is, Indonesian-based concessionaires Several also claimed that they are having to travel are assumed to be enjoying such high rents that they greater distances than in the past to obtain commer- are able to afford the additional financial obligations cially valuable timber, and that the added transport that sustainability imposes. To the extent that costs have cut into their profits. While anecdotal claims sustainable concession management is not profitable of this sort should not be interpreted to mean that for private timber operators, they can be expected rents no longer exist in Indonesia’s timber sector, they either to withdraw from the timber sector or, more do suggest that some concessionaires may no longer likely, to resort to increasingly unsustainable practices be enjoying the high excess profits that they did in the for as long as they are able to. Simply put, HPH-holders past. will not play by the rules if it is not profitable for them to do so. Assessment of Current Rent Levels Through much of the New Order period, there was To better assess whether sustainable concession a general consensus that Indonesia’s HPH system did, management is, in fact, viable for a majority of indeed, generate high rents and that a substantial Indonesian HPH-holders, it is useful to examine the portion of these accrued to private timber operators in concession rent studies conducted by the Indonesia- the form of excess profits. Ruzicka (1979), for instance, UK Tropical Forest Management Programme estimates that in the mid-1970s, medium- and large- (ITFMP). These studies offer the most detailed scale concessionaires in East Kalimantan were able to calculations of timber sector profitability in recent capture 67 to 75 percent of the rents associated with years. Based on the results of a 1995 survey of 31 their logging activities, yielding average annual returns concessions located in five provinces, ITFMP has of 120 to 150 percent. Similarly, Ahmad and Ramli developed a Forest Concession Model, which estimates (1991) concluded that the government allowed private the economic rent that concessionaires obtain from their operations for a given log price and production 17 Interview with Kim Young Cheol, manager of Forestry Division, Korindo Group, costs. Using this model, Scotland (1999) estimates February 25, 2000.

49 that prior to the onset of the economic crisis in July by the HPH system that are actually collected by 1997, a timber operator with a 15-year old concession concession-holders as excess profits—7.6 percent of 115,000 ha—characteristics purportedly selected before the crisis and a mere 3.5 percent since the “to represent an average concession in Indonesia”— crisis began.18 Under either set of conditions, it is not enjoyed an internal rate of return of 19 percent. at all clear that a substantial majority of Indonesia’s Total economic rent under those conditions stood at concession-holders would be able to continue US$42.00 per m3, corresponding to excess profits of operating profitably if timber royalties were raised US$3.16 per m3 for the concessionaire, assuming a significantly and a performance bond equivalent to 30 15 percent discount rate. percent of annual operating costs were imposed, as the In estimating rent levels after the monetary crisis World Bank has recommended. Unfortunately, the began, Scotland assumes that most concessionaires ITFMP model does not account for the considerable adopted a range of cost-cutting measures to compen- variation in operating costs or productivity--and, sate for the sharp devaluation of the rupiah. These therefore, rent levels--that exists across geographic included switching to exclusive use of the rupiah in space and among firms with different processing order to minimize dollar expenditures; placing a capacities, investment strategies, and management moratorium on all large capital purchases; and objectives. As such, it does not reliably predict what reducing by 50 percent all non-essential expenditures-- portion of HPH-holders would lose money if they did anything not directly related to felling operations and not manage their concessions sustainably. the sale of timber. With these adjustments, it is As Scotland’s study is based upon figures derived estimated that timber operators were able to generate from a hypothetical “representative” concession, its an internal rate of return of 27 percent, which was just conclusions extrapolate from the assumption that all slightly higher than the assumed post-crisis discount concessions are able to obtain 28 m3 of commercial rate of 25 percent. In response to the precipitous drop timber per hectare and that 70 percent of their species in domestic log prices, rent levels are believed to have mix is made up of valuable meranti. While it is fallen to US$13.50 per m3 during the months after the acknowledged that these figures are “undoubtedly crisis began, leaving concessionaires to capture higher than production in marginal and degraded US$0.60 per m3 in excess profits. From these figures, concessions, the latter of which there are many,” the Scotland estimates that during the first year of the study offers little sense of the ranges of productivity or crisis, aggregate rents associated with Indonesia’s profitability associated with such sites either before or logging industry were US$447 million, of which approximately US$16 million accrued to the private 18 Clearly, it is important to recognize that most of Indonesia’s timber concessions are controlled by integrated timber conglomerates, through which they are linked to plywood sector as excess profits. By comparison, total rents and sawmills. A portion of the rents associated with a concession is often transferred to before the crisis began were on the order of US$1.1 these industries through the sale of roundwood to an allied processing firm at artificially billion per annum, of which US$84 million went to low prices, a process known as transfer pricing. Moreover, by adding value to the logs they consume, these industries generate additional rents for each cubic meter of concession-holders (Scotland 1999). roundwood processed (see Scotlandand Whiteman, 1997:12). As concessions and What is striking about these numbers is the processing operations become increasingly separated, however, timber groups will have no reason to use rents generated from processing to subsidize concessions if they are relatively small portion of the total rents generated not profitable in their own right.

50 after the crisis (Scotland 1999, 15). In fact, however, the cessions only begin to register a profit when they are rent survey on which the ITFMP Forest Concession 80,000 hectares or larger (Scotland 1999, 19-20). At Model was constructed found that no fewer than 10 of the assumed post-crisis discount rate of 25 percent, he the 31 firms covered had productivity levels of 15 m3 argues that concessions smaller than this show a per hectare or less. The least productive of these sites negative net present value and that economic rent on reported yields of only 5 m3 per hectare. each cubic meter of roundwood produced falls below Moreover, anecdotal evidence from interviews the log levies collected by the government. These conducted during the course of the present study findings, therefore, suggest that a significant portion suggests that meranti accounts for substantially less of Indonesia’s concessionaires have not been able to than 70 percent of the timber currently being harvested maintain their economic viability if they adhere to the at many HPHs. Several industry sources indicated that government’s regulations through much of the period there has been a marked decline in high-value, large- since the crisis began. diameter meranti in most timber-producing regions In addition, Scotland’s analysis was prepared in early over the past 10 to 15 years. As such, many concession- 1999 when international petroleum prices were low, and aires are now cutting smaller-diameter stems and a when domestic fuel prices were being heavily subsi- broader range of species than in the past. Former dized by the Indonesian government to keep them at Apkindo Chair Bob Hasan described this process roughly 30 percent of international rates. As a result, as follows: the potentially large impact of fuel costs on profit margins is not readily apparent in the rent levels calcu- Through the 1970s and 1980s, most of what we cut lated. Because it is improbable that domestic fuel prices was meranti. The trees were enormous and we could will remain at such low, subsidized rates for very long, pick which ones we wanted. Generally, we chose those many concessionaires, particularly those that must haul 60 cm and up. Now, the big meranti is much more their logs overland, are likely to face substantially scarce and harder to get. At least half of what we higher transportation costs over the medium term than harvest is other species.19 those estimated. To some extent, this decline in high-value meranti The point of this discussion is not to critique logs has been obscured by the fact that, since the early Scotland’s study, which, indeed, offers the most serious 1990s, the Indonesian Timber Society (Masyarakat analysis of concession-holder profits since the econo- Perhutanan Indonesia) has encouraged its members to mic crisis began.Nor is it to imply that Indonesian market a variety of species with properties similar to concession-holders are no longer making profits. It is, Shorea as “meranti group.” rather, to underscore the manner in which discussions Scotland uses the ITFMP model to estimate forest of Indonesian timber rents have often overstated the concession profitability and levels of economic rent profits available to a substantial portion of the nation’s associated with HPHs of varying sizes. He finds that concessionaires. Timber companies with the largest, under the post-crisis scenario, there is a substantial most productive, and most accessible HPHs were economy of scale in the timber sector and that con- clearly capturing sizeable rents before the crisis, and

19 Interview with Mohamad “Bob” Hasan, former Chair of Apkindo, May 3, 1999. most have apparently continued to enjoy excess profits

51 on a more modest scale since the crisis began. Dwindling Prospects for Rents Over the Long-Term However, timber companies with smaller, less produc- By definition, sustainable concession management also tive, and/or remote concessions have been operating involves the maintenance of a site’s productivity at a much closer to the margins of profitability. It is likely commercially viable level for an indefinite number of that many have resorted to illegal, and presumably harvests beyond the first logging rotation. Such unsustainable, practices in order to maintain their systems generally take into account the fact that profit levels. second harvests are almost always lower than first This poses an important practical challenge for the harvests. At least in theory, they are designed to World Bank and other agencies that have recommend- maintain all subsequent harvests at levels that are ed that the Indonesian government raise its timber similar to the second cut as well as profitable. royalties and to introduce performance bonds. Indonesia’s TPTI selective cutting system is based on Together, these two fees will need to be large enough the assumption “that a residual stand after logging will that they motivate concessionaires to employ sustain- contain an adequate stocking of sound, commercial able management practices, but not so high that they species trees of 20 cm dbh or more, which will grow inhibit timber operators from generating a reasonable into an economically harvestable timber in 35 years profit at the prevailing discount rate. As mentioned from the original logging date” (World Bank 1993:38). above, concession-holders cannot rationally be To be successful, the TPTI system is dependent on expected to manage their HPHs sustainably if it is not commercial species in the logged-over forest sufficiently profitable for them to do so. Given the regenerating at a rate of at least 1 cm per year, so that range of rent levels that appears to exist across space, there is an adequate number of stems with a diameter companies, and time, it is difficult to imagine how the of 50 cm and up when the second rotation begins. government will be able to increase its own rent cap- With a growing number of concessions in ture and impose effective performance bonds without Indonesia’s Outer Islands nearing the end of their first also pushing a segment of the industry’s concession- 35 year rotation, the question of whether there will be holders out of business. Several industry officials trees of adequate size and value to make sustainable interviewed indicated that to the extent these fees management profitable during the second harvesting reduced the profitability of their own logging opera- cycle is emerging as a critical issue. Many of the tions, their firms would shift toward sourcing their concession-holders interviewed for this study indicated logs from the open market. In practical terms, this that they anticipate that the second rotation may, in would imply a growing reliance by many wood fact, not be profitable if the concession is managed for processors on illegally and unsustainably harvested ‘sustained yield.’ Some questioned the theory behind timber. the TPTI system, claiming that the trees at their concession sites did not grow at a rate of 1 cm per year and, therefore, would not fully regenerate in 35 years. Others reported that noncommercial or lesser-value species dominated the residual stand after the first rotation. Several industry studies have documented

52 the fact that collateral damage during logging management practices will be at all profitable in areas operations is often severe, with the effect that it sharply entering their second rotation—a prospect facing limits the sites’ future productivity. Post-logging concessions allocated in the late 1960s within the next surveys in the early 1990s estimated that damage and five years, and a rapidly growing number after that. In mortality in residual stands was frequently in the range fact, there is growing evidence that in many parts of of 35 to 50 percent (World Bank 1993). Sumatra and Kalimantan, timber concessions subject to In interviews, several industry officials noted that repeated logging and other forms of disturbance will logging companies frequently have little incentive to have no commercial volume remaining at the point that leave commercially valuable stems standing in residual the second logging rotation is due to begin. forests, as there is often scant hope that these trees will remain in place or that their firms will have continued ASSUMPTION #5: The Indonesian government access to them until the second rotation begins. has the institutional capacity to enforce the Although the World Bank has used this to justify proposed changes in the HPH system and the extending the HPH contract from 20 to 35 years, there forest products trade. is growing evidence that, in fact, longer concession periods will hardly be adequate to counteract such To be implemented effectively on any large scale, pressures. With timber roads and skid trails providing the reforms put forth by proponents of the “sustainable easy access, logged-over areas are often highly suscep- logging” paradigm would require a considerable tible to encroachment on the part of illegal loggers and degree of institutional capacity on the part of the settlers. Some companies also reported that after their Indonesian government.5 According to the reform initial harvest, portions of their concession areas have agenda proposed by the World Bank, the government’s been reclassified by the Ministry of Forests for other central task in the forestry sector is to reduce aggre- uses such as plantations and transmigration. gate roundwood production by roughly 30 million m3 Consequently, it is common practice for concession- per year. The Bank argues that the government will be holders to re-log a regenerating stand prematurely, a able to achieve this by regulating concession manage- practice known as cuci mangkok (literally, “washing the ment practices more tightly and by removing restric- bowl”). In fact, some concessionaires are known to tions on the marketing of logs and other wood have intentionally logged in degraded and cut-over products. To be even minimally successful in accom- areas in order to encourage the Forestry Department plishing these, the government would need to have to reclassify their HPH sites as conversion forest. the following institutional capabilities: Logged-over areas have also been particularly 1) mechanisms to monitor and enforce the susceptible to the widespread forest fires of the last few use of sustainability practices on the part of years, which has further diminished the availability of concessionaires within their HPHs; second-rotation timber (Dennis and Hoffmann 2000; Hoffmann, et al. 1999). 2) the capacity to enforce concession boundaries in The combination of these factors raises serious order to restrict outside actors from encroaching doubts as to whether sustainable concession on HPHs;

53 3) the ability to keep concession-holders and others needed to regulate the activities of either formal from logging in areas that have not been concession-holders or the various actors involved in designated for commercial timber extraction; informal timber harvesting. Under the decentralized system, significant responsibilities for forest sector 4) an effective system of surveillance and chain-of- policymaking and planning are also likely to remain custody to control both the domestic timber trade with the Ministry of Forests in Jakarta, while and log exports. implementation responsibilities lie with the provincial and district governments. This implies that implemen- For several reasons, it appears highly unlikely tation of a coherent policy for sustainable timber that the Indonesian government will, at any point in extraction will require a substantial amount of the near future, have the institutional capacity needed coordination across the various tiers of government, to make systemic changes in the HPH system and the which in many cases have competing institutional nation’s forest products trade. From a purely logistical interests.20 perspective, the need to enforce rigid, exclusionary Complicating matters significantly, units of the boundaries around areas designated as HPHs and to military, national police force, and other arms of the monitor the harvesting practices of close to 400 state apparatus are known to be heavily involved in concession-holders poses a number of formidable illegal logging in most timber-producing provinces challenges. Indonesia’s total concession area currently (McCarthy 2000, Telapakand EIA, 1999). It is likely extends over 49 million hectares, much of which is that the involvement of such actors could become located in remote regions or covers terrain that is more entrenched as the state becomes weaker and/or difficult to access. The state forestry bureaucracy, more decentralized and as these agencies are less able which, since 1967, has been charged with managing to rely on formal budgetary allocations to support their 75 percent of the nation’s land mass, is understaffed, operations.21 While the World Bank and others have poorly trained, and ill-equipped to administer such a proposed the establishment of an independent moni- large area. Moreover, the vast majority of the Ministry toring system to regulate concessionaire management of Forests personnel are concentrated in Java, Jakarta, practices, it is difficult to imagine how such a system and provincial capitals. could function without the active support of the state’s Some observers anticipate that such institutional own law enforcement agencies. In any case, it would weaknesses are likely to be exacerbated by the current decentralization process, in which authority over forest 20 To date, the district, provincial, and national governments have shown little administration is shifting from Jakarta to provincial willingness or capacity to coordinate effectively in the areas of forestry planning or regulation. In East Kalimantan and other timber-rich provinces, district officials have and district governments. Until now district govern- frequently allocated small-scale logging and forest conversion permits in areas that fall ments have played a minimal role in administering the within the boundaries of HPH timber concessions previously allocated by the Ministry forests within their jurisdictions. Most have little of Forestry in Jakarta. 21 In a recent news interview, Minister of Defense Juwono Sudarsono stated that technical capacity to assess whether timber companies formal budget allocations currently “only account for around 25 percent of the are adhering to the government’s regulatory guide- minimum budget needed for TNI [Indonesian Army] operational costs” (Jakarta Post, May 24, 2000). Juwono noted that “because minimum standards to enhance lines for sustainable concession management. professionalism are not met, there are many [military officers] who are involved in Likewise, few, if any, have the enforcement capacity unsavory activities, including ‘influencing’ legal processes.”

54 appear that reducing effective demand for logs by Assume, without evidence, that the Indonesian closing some processing mills would be an easier, and government has the institutional capacity needed arguably more effective, strategy to implement than to make systemic changes to the HPH system and controlling log supply. the forest products trade. ______

CONCLUSION: REORIENTING In assessing the prospects for environmental TIMBER SECTOR REFORM sustainability in Indonesia’s forestry sector, this Over the last 15 years, the policy dialogue in analysis has largely focused on policy reforms Indonesia’s forestry sector has been dominated by pro- proposed by the World Bank since the mid-1980s. It is posals to reform the HPH timber concession system. important to recognize, however, that the Bank has The central aim of these reforms has been to reduce hardly been alone in arguing that sustainability can Indonesia’s aggregate timber extraction rates to the best be achieved by modifying the HPH concession supposedly sustainable level of 25 million m3 per year. system and regulatory structures framing the nation’s As argued in this chapter, the World Bank and others forest products trade. Indeed, many forest economists promoting environmental sustainability through and policy analysts have joined the Bank in calling on improved concession management are unlikely to the Indonesian government to better enforce its achieve this objective under the circumstances that selective cutting guidelines; to increase its capture of currently exist in Indonesia’s forestry sector. The timber resource rents; and to encourage market-based effectiveness of the proposed policy interventions is efficiency in log harvesting, processing, and trade. likely to be limited in that they: Moreover, proponents of the ‘sustainable logging’ ______paradigm have advocated a very similar set of policies Seek to control timber supply without reducing in many countries besides Indonesia. These include effective demand on the part of Indonesia’s wood- based industries. tropical timber-producing countries as diverse as ______Cameroon, Guyana, Malaysia, and Papua-New Guinea. Overlook or inadequately address roundwood While sustainable forest management is clearly an extraction from large areas, including areas important goal to be pursued by the World Bank or designated protection and conversion forest, as other agencies seeking to leverage reforms on the part well as areas under Inhutani control. ______of the Indonesian government, it loses much of its Fail to provide a credible plan for reducing illegal legitimacy to the extent that it is fundamentally logging. unachievable on any large scale. This, in turn, raises ______important questions about what priorities should guide Encourage investments in efficiency without the policy reform process in Indonesia’s timber sector. regard for the often damaging impacts that such The following sections outline three major directions in investments may have on natural forests. ______which the reform process should be reoriented. Assume that sustainable concession management is profitable over both the short and long term, in spite of strong indications to the contrary. ______

55 Limiting Demand for Roundwood policymakers from a range of government agencies, The considerable logistical difficulties associated with civil society organizations, and forest industry groups. controlling timber supply in Indonesia suggest that any As a first step, these actors would need to develop serious effort to relieve pressures on the nation’s criteria for determining which mills should be subject remaining natural forests should involve proactive to capacity reduction measures or closure. Clearly, this steps to limit demand for wood on the part of domestic should not be based simply on which mills hold the forest-based industries. With illegal logging going largest amounts of outstanding corporate debt. Rather, virtually unchecked in most timber-producing it should include detailed and transparent assessments provinces, it is probable that Indonesia’s annual log of whether: harvest will greatly exceed the legal and sustainable these mills have verifiable access to legal and harvesting levels as long as a substantial “structural sustainable raw material supplies; timber deficit” remains in place. Industrial overcapacity ______in Indonesia’s wood-processing sector was identified as their operations have a profoundly negative impact a critical problem facing the forestry sector at the on the surrounding environment; February 2000 meeting of the Consultative Group on ______Indonesia, placing the issue squarely on the forestry their activities have led to social conflicts with local sector policy agenda. There, both the government and communities which threaten either the viability of the international donor community agreed to take the processing enterprise or the socio-political immediate steps toward “closing illegal sawmills” and stability of the region in which they are operating; ______“downsizing and restructuring of [Indonesia’s] wood- the processing enterprise carries an inordinate based industry [in order] to balance supply with degree of financial risk. demand for raw materials” (Keating 2000). ______To implement these commitments, it will be necessary for the Indonesian government and Slowing Forest Conversion international donors to define practical steps that can To the extent that policymakers do seek to control be taken to reduce the demand for wood by domestic Indonesia’s wood supply, their focus will need to processing industries, and to identify which agencies extend beyond restricting log output from the HPH would need to carry these out. In this regard, it is system. Sharp reductions in roundwood harvests can significant that the Indonesian Banking Restructuring only be achieved if steps are taken to significantly Agency (IBRA) now controls many of Indonesia’s reduce the pace at which Indonesia’s remaining wood processors, either in whole or in part (see natural forests are being converted to other uses. To Chapter 5). To the extent that IBRA chooses to call in its credit, the World Bank secured from the govern- outstanding loans held by forest sector debtors, it can ment a temporary moratorium on the allocation of exert a great deal of leverage in carrying out reduc- forested land for conversion to oil palm and other tions in processing capacity at both the firm and agroindustrial crops, in late 1998. This moratorium industry levels. In playing such a role, it would clearly should be maintained at least until detailed surveys be necessary for IBRA to work closely with have been carried out to determine whether

56 appropriate nonforested areas are available for such Shifting the Agenda Toward Equity projects, and until existing legal claims on such land The recognition that, at this point, sustainable have been resolved. Moreover, efforts should be made concession management is fundamentally to ensure that subsidies in the form of underpriced unachievable on any large scale begs the issue of who IPK wood, discounted capital and loan guarantees, should have access to and control over the nation’s or corporate debt write-off do not offer perverse forest resources. Through the New Order period, incentives for agroindustrial conglomerates to clear both the Ministry of Forestry and many advocates of new tracts of forested land. the “sustainable logging” paradigm routinely argued In addition, Indonesian government policymakers that large, privately owned logging companies should be encouraged to seriously consider placing connected to processing facilities are the most restrictions on the allocation of new IPK licenses to appropriate actors pulp mills and other wood processors. Companies for managing areas designated as production forest in seeking access to IPK wood should be required to Indonesia’s Outer Islands. The stated rationale was provide verifiable documentation that they are making that such actors would have an incentive to manage adequate progress in establishing plantations in order their concessions sustainably because they have both to ensure that their operations will eventually be a long-term investment in processing which relies on sustainable over the long term. Policymakers may also continued access to timber supplies, and an economy wish to consider requiring IPK license holders to pay of scale that enables them to run their harvesting higher royalties on the wood they harvest in order operations efficiently. to ensure that its costs are comparable to the costs In this way, the principle of sustainability has often associated with obtaining wood from industrial wood been used to legitimize the extreme inequity around plantations. which the HPH system was structured during the Finally, the Indonesian government should be Suharto era. In practice, it appears that some large- encouraged to restrict the use of logging in areas scale timber operators may, indeed, have adhered to allocated to the Inhutani state forestry enterprises for the government’s selective harvesting and replanting ‘rehabilitation’ purposes. More generally, efforts regulations. However, a far larger number have should be made to establish a clear code of account- employed indiscriminate logging practices to liquidate ability for the Inhutanis and mechanisms for monitor- as rapidly as possible the timber resources made ing the forest areas under their control, although such available to them by the state. efforts would almost certainly be hindered by many of Recognizing sustainability of forest management by the same factors that limit monitoring of existing large-scale enterprises to be untenable under the HPHs. This latter point is especially critical in light of current circumstances makes it impossible to justify the Ministry of Forestry proposal in mid-2000 to maintaining the New Order regime’s policy of transfer all of Indonesia’s existing HPHs to Inhutani categorically excluding forest-dependent communities management. from areas that the state has defined to be production, protection, or conversion forest. On the contrary, the demise of sustainability as an achievable policy goal

57 suggests that equity for local communities with Chapter Three: Sources Cited clear historical or customary (adat) claims to forest Ahmad, Mubariq and Rizal Ramli. 1991. Rente ekonomi dalam pengelolaan land should, in fact, be a central principle guiding hutan alam. WALHI. Jakarta, Indonesia. forestry sector reform in the present context. Ascher, William. 1998. From oil to timber: the political economy of off- budget development financing in Indonesia. Indonesia 65: 37–61. The current decentralization process has, in fact, Asnawie, Sofyan. 2000 “Penjarahan kayu diperbatasan kembali marak.” created new opportunities for advancing an equity- Tarakan Post, 15-22 January. Badan Pusat Statistik (BPS). 1999. “Statistik perdagangan luar negeri based agenda in the forestry sector, as far-reaching Indonesia, Ekspor/Export 1998.” Jakarta, Indonesia. authority over forest administration now lies in the Barbier, E.B., N. Bockstael, J.C. Burgess, and I. Strand. 1995. “The hands of district governments. Linkages Between the Timber Trade and Tropical Deforestation – Indonesia.” World Economy 18: (3) 411-442. Clearly, the legal recognition of local tenure Barr, Christopher. 1999. “Discipline and Accumulate: State Practice and will not, in itself, guarantee that any given tract Elite Consolidation in Indonesia’s Timber Sector, 1967-1998,” M.Sc. thesis, Cornell University, Ithaca, New York. of forest would remain standing longer than if a Brown, David W. (1999) “Addicted to Rent: Corporate and Spatial timber concessionaire managed it. It would, Distribution of Forest Resources in Indonesia; Implications for Forest however, provide the basis for ensuring that Sustainability and Government Policy,” DFID/Indonesia-UK Tropical Forest Management Program, Report No. PFM/EC/99/06. members of forest-based communities would have Colfer, Carol. J. Pierce. 1983. “Change and Indigenous Agroforestry in legitimate authority to determine how the forest East Kalimantan.” Borneo Research Bulletin 15(1&2):3-20,70-86. De Kock, Robert. B. 1999. “Yield Regulation for KPHP.” Indonesia-UK resources on which their livelihoods depend Tropical Forest Management Programme, Report No. should be managed and to share equitably in PFM/SILV/99/3, Jakarta, Indonesia. the benefits of any products harvested from the Dennis, Rona. and A. Hoffmann. 2000. “Large-Scale, Catastrophic Fires and Secondary Forests in Indonesia.” Paper prepared for the areas under their jurisdiction. Moreover, numerous workshop “Tropical Secondary Forests in Asia: Reality and studies have shown forest-dependent communities Perspectives,” April 10-14, Center for International Forestry Research (CIFOR), German Agency for Development (GTZ), and in many parts of Indonesia to consist of highly Expertisecentrum LNV (formerly IKC Natuurbeheer), Samarinda, skilled resource managers, who have sustained Indonesia. Departemen Kehutanan (various years). Statistik kehutanan Indonesia. complex forest ecosystems for generations Biro Perencanaan, Sekretariat Jendral Departemen Kehutanan, (Fried 1995; Dove 1986). Jakarta, Indonesia. Direktorat Bina Pengushaan Hutan. 1999a. “Realisasi produksi kayu bulat, khusus RKT-PH.” Unpublished statistics, Departemen Kehutanan, Direktorat Jenderal Pengusahaan Hutan, Jakarta, Indonesia. Direktorat Bina Pengushaan Hutan. 1999b. “Produksi kayu bulat areal konversi.” Unpublished statistics, Departemen Kehutanan, Direktorat Jenderal Pengusahaan Hutan, Jakarta, Indonesia. Direktorat Penyiapan Pengusahaan Hutan. 1998. Laporan hasil monitoring dan evaluasi perkembangan HPH sampai dengan bulan Maret 1998. Departemen Kehutanan, Direktorat Jenderal Pengusahaan Hutan, Jakarta, Indonesia. Djamaludin. 1989. “The Implementation of Indonesian Selective Cutting and Replanting (TPTI) Silviculture System for Timber Improvement in the Logged-Over Areas.” In Proceedings of the Fourth Round-Table Conference on Dipterocarps (Soerianegara, I. et al., eds.), 12-15 December, Biotrop Special Publication No. 41, Bogor, Indonesia,. Dove, Michael. 1986. “The Ideology of Agricultural Development in Indonesia,” in Central Government and Local Development in Indonesia, ed. C. McAndrews. Singapore: Oxford University Press.

58 Fried, Stephanie. 1995. “Writing for Their Lives: Bentian Dayak Authors Sacerdoti, Guy. 1979. “Where Timber is Booty.” Far Eastern Economic and Indonesian Development Discourse.” Ph.D. dissertation, Cornell Review, November 30, pp. 64-65. University. Schwarz, Adam. 1994. A Nation in Waiting: Indonesia in the 1990s. Gillis, Malcolm. 1988. “Indonesia: Public Policies, Resource Management, Boulder, Colorado: Westview Press. and the Tropical Forest” in Public Policies and the Misuse of Forest Scotland, Neil. 1999. “The Impact of the Southeast Asian Monetary Crisis Resources, ed. Robert Repetto and Malcolm Gillis. New York: on Indonesian Forest Concessions and Implications for the Future.” Cambridge University Press, pp. 43-114. Indonesia-UK Tropical Forest Management Program, ODA-DFID Gray, John A. and Hadi Soetrisno. 1989. “Forest Concessions in Indonesia: Report No. SMAT/EC/98/02, Jakarta, Indonesia. Institutional Aspects.” Forestry Studies report UTF/INS/065, Ministry Scotland, Neil, Alastair Frazer, and Nick Jewell. 1999. “Roundwood Supply of Forestry/FAO. Jakarta. and Demand in the Forest Sector in Indonesia.” Indonesia-UK Tropical Hoffmann, A.A., A. Hinrichs, and F. Siegert. 1999. Fire Damage in East Forest Management Programme, Report No. PFM/EC/99/08 Kalimantan in 1997/98 Related to Land Use and Vegetation Classes: (November 23rd draft). Jakarta, Indonesia. Satellite Radar Inventory Results and Proposal for Further Actions. Scotland, Niel and Adrian Whiteman. 1997. “Economic Rent in the IFFM-SFMP Report No.1a (1999). MOFEC, GTZ and KfW, Jakarta, Indonesian Forest Sector, Volume 4: The Forest Concession Industry.” Indonesia. Indonesia-UK Tropical Forest Management Program, ODA-DFID Indonesia-UK Tropical Forest Management Programme (ITFMP). 1999. Report No. SMAT/EC/97/04, Jakarta, Indonesia. “Illegal Logging in Indonesia,” Report No. PFM/EC/99/03. Sunderlin, William. 1998. “Between Danger and Opportunity: Indonesia’s Ingram, Denise. 1989. “Analysis of the Revenue System for Forest Forests in an Era of Economic Crisis and Political Change.” Resources in Indonesia.” Forestry Studies Report UTF/INS/065, field http://www.cgiar.org/cifor/. September 11. document no. VI-2, Ministry of Forestry/FAO, Jakarta, Indonesia. Telapak Indonesia and Environmental Investigation Agency (EIA). 1999. Jakarta Post. 2000. “Military Faces Acute Budget Problems: Juwono.” “The Final Cut: Illegal Logging in Indonesia’s Orangutan Parks.” May 24. Bogor, Indonesia. Kartodihardjo, Hariadi. 1999. “Economic Loss of the State in Managing Vincent, Jeffrey. R. 1992. “The Tropical Timber Trade and Sustainable Natural Forest.” Unpublished paper prepared for Telapak Indonesia Development.” Science 256:1651-55. and Environmental Investigation Agency, August 24. World Bank. 1998. “World Bank Involvement in Sector Adjustment for Kartodihardjo, Hariadi. and Agus Supriono. 1999. Dampak pembangunan Forests in Indonesia: The Issues.” Unpublished Draft Issues Paper sektoral terhadap degradasi alam: Kasus pembangunan HTI dan (October). perkebunan di Indonesia. CIFOR, Bogor, Indonesia. World Bank. 1995. “The Economics of Long-Term Management of Keating, John. 2000. New hope for Indonesia’s forests. The Jakarta Post. Indonesia’s Natural Forest.” Unpublished Paper (August). February 4. World Bank. 1993. “Indonesia – Production Forestry: Achieving Lindsay, Holly. 1989. “The Indonesian Log Export Ban: An Estimation of Sustainability and Competitiveness.” Unpublished Draft Working Foregone Export Earnings.” Bulletin of Indonesian Economic Studies Paper (October). 25 (2). World Wide Fund for Nature (WWF) and Department for International Manurung, E.G. Togu. and Joseph Buongionro. 1997. “Effects of the Ban Development (DFID). 1998. “Laporan Perkembangan Sawmill di on Tropical Log Exports on the Forestry Sector of Indonesia.” Journal Wilayah Selatan Taman Nasional Bukit Tigapuluh & di Sekitar of World Forest Resource Management 8:21-49. KPHP Pasir Mayang.” Indonesia-UK Tropical Forest Management McCarthy, John. 2000. “Wild Logging:” The Rise and Fall of Logging Programme, Jambi, Indonesia. Networks and Biodiversity Conservation Projects on Sumatra’s Rainforest Frontier. Center for International Forestry Research occasional paper no. 31. Bogor, Indonesia: CIFOR. Ministry of Forestry. 1995. Country Brief – Indonesian Forestry Action Programme. Jakarta, Indonesia. Purnama, Boen, W. Rusmantoro, and Paul R. van Gardingen. 1999. The Selection of Silvicultural Systems for the Management of Primary and Logged-Over Dipterocarp Forests in Indonesia: the Case Against the Application of TPTJ. Balai Penelitian Kehutanan Samarinda and DFID UK-Indonesia Tropical Forest Management Project, Jakarta, Indonesia. Reuters. 2000. “Indonesia to Hand Forest Control to State Firms.” May 4. Ruzicka, Ivan. 1979. “Rent Appropriation in Indonesian Logging: East Kalimantan 1972/73 – 1976/77.” Bulletin of Indonesian Economic Studies, Vol. XV, pp. 45-74.

59 The Political-Economy of Fiber and Finance

in Indonesia’s Pulp and Paper Industries 1

Chapter 4 Since the late 1980s, Indonesia’s pulp and paper The growth of Indonesia’s pulp and paper industries industries have expanded rapidly to push the country over the past decade has involved an aggregate capital into the ranks of the world’s top 10 producers. investment of at least US$12 billion. In both industries, Indonesia’s pulp production capacity grew from there has been a trend toward the development of 606,000 to 4.9 million metric tonnes per year between processing facilities with very large production 1988 and 2000, while the paper industry’s processing capacities, which have generally entailed high fixed capacity rose from 1.2 million to 8.3 million tonnes per costs—in several cases, exceeding US$1 billion per year (Spek 2000b). Last year, pulp and paper products mill (Bell 1997; Spek 2000a). These large investments generated US$2.9 billion in export earnings, have often been justified as enabling Indonesian accounting for over 50 percent of the country’s forest- producers to remain profitable in highly cyclical pulp related exports (Bank Indonesia 2001). and paper markets by producing large volumes of The meteoric growth that has occurred in both product at low cost (Spencer and Choi 1999). The fact industries, however, has proceeded far more rapidly that Indonesian companies have made investments on than efforts to secure a sustainable supply of raw this scale without first securing a legal and sustainable materials through the development of pulpwood raw material supply, however, suggests that many of plantations (Cossalter 1998). Of the 120 million m3 of these projects carry a substantial degree of financial wood estimated to have been consumed by the pulp risk. industry during 1988-2000, only 10 percent was To a significant degree, Indonesian pulp and paper harvested from plantations.2 To date, Indonesia’s pulp companies have been motivated to invest such large mills have relied heavily on unsustainable and, in many sums in high-risk projects because their owners have cases, illegal sources of fiber, much of which is been able to avoid much of the financial risk involved. obtained through the clear-cutting of natural forests. Three factors have enabled them to do so: First, the During this period, demand for pulpwood is estimated Indonesian government has provided substantial to have caused the loss of over 900,000 ha of natural capital subsidies to pulp and paper producers, forest. Although the industry’s largest producers are including the provision of pulpwood fiber at costs well now taking steps to bring online industrial pulpwood below its stumpage value. Second, the government’s plantations (hutan tanaman industri, or HTIs), it is weak regulation of the nation’s financial system has projected that most of the country’s pulp mills will face enabled pulp and paper companies to employ a variety sizeable deficits of sustainably harvested fiber for at of illegal practices to obtain discounted finance. Third, least the next seven years, and quite possibly well international financial institutions have helped beyond. Indonesian producers to borrow billions of dollars

1 The paper on which this chapter is based was initially released on CIFOR’s web from offshore investors without rigorously assessing site in November 2000, with the title “Profits on Paper: the Political Economy of either the long-term viability of those firms’ fiber Fiber, Finance, and Debt in Indonesia’s Pulp and Paper Sector.” For the purposes of this book, the issue of corporate debt has been placed in Chapter Five. Since the supplies or the legality of their financial practices. first version of this paper was circulated, some revisions have also been made to In spite of the considerable structural pressures that the sections on the fiber supply strategies of PT Indah Kiat Pulp & Paper and PT Indonesia’s pulp and paper industries have placed on Riau Andalan Pulp & Paper, based on information provided by the companies. 2 These figures are derived from APKI (1997), Jaakko Poyry (1998) and Spek natural forests, they have been largely overlooked by (2000b).

60 the World Bank and other agencies involved in the are directly linked to affiliated paper production post-1997 forestry adjustment process, due mostly to facilities. Both groups have been active in Indonesia’s the Bank’s absence from Indonesia’s forestry sector pulp and paper sector since at least the mid-1980s, and during the years immediately prior to the financial for the last several years, each has coordinated its crisis. Indeed, it was during these years that the pulp operations through a Singapore-incorporated holding and paper industries underwent accelerated growth, company. The Sinar Mas Group has financed much of while the country’s plywood industry began its slow its expansion through Singapore-based Asia Pulp & decline. The Bank’s policy interventions have generally Paper (APP), while the Raja Garuda Mas Group has focused on timber concession management, rather used Asia Pacific Resources International Ltd. than pulpwood fiber supply, because the HPH system (APRIL), a Singapore-based holding company, to dominated Indonesia’s forestry sector when the Bank coordinate its activities in the sector. was involved in the early 1990s. The Sinar Mas/APP Group is by far the dominant Given the amount of capital invested in Indonesia’s player in Indonesian pulp processing as well as paper pulp and paper industries, it is also striking that the and board production. The group owns two of the World Bank and the IMF have until now failed to nation’s largest pulp mills: Indah Kiat and Lontar address the real financial risks associated with unsus- Papyrus, located respectively in the east Sumatran tainable fiber supplies. Arguably, this reflects the provinces of Riau and Jambi (see Figure 4.1). Between limitations of sectorally focused policymaking. The 1991 and 1999, the group’s pulp processing capacity agencies involved in reforming Indonesia’s financial grew from 410,000 tonnes to 2.3 million tonnes per sector and restoring macroeconomic growth clearly year (Ausnewz 1999). During the same period, Sinar recognize the significant exchange earnings made Mas/APP mounted an aggressive series of expansions by pulp and paper producers. However, they have and acquisitions to raise the group’s paper and board shown little recognition that the financial viability of production capacity in Indonesia from 383,000 to 3.8 Indonesia’s pulp mills is ultimately dependent on their million tonnes per year (Ausnewz 1999). Since the mid- ability to secure long-term supplies of fiber from 1990s, APP has also initiated investments in five paper pulpwood plantations. and board facilities in China, which currently have an aggregate production capacity of 1.8 million tonnes per Pulp and Paper Capacity year (APP 2000). Following these massive capacity Expansion During the 1990s expansions, APP has emerged as the world’s eighth Four large conglomerates have accounted for virtually largest paper and board producer and the largest in all of the growth that has occurred in Indonesia’s pulp non-Japan Asia (James, et al. 2000). industry over the past decade. For analytical purposes, The Raja Garuda Mas/APRIL Group has pursued a these groups can be divided into two categories: similarly aggressive expansion strategy over the past integrated producers and producers of market pulp. decade, albeit on a much smaller scale. Like Sinar Integrated producers include the Sinar Mas and Raja Mas/APP, the group controls two Indonesian pulp Garuda Mas groups, each of which has sought to processing facilities: Riau Andalan Pulp & Paper establish large-scale pulp processing operations that (RAPP) and Indorayon, located respectively in Riau

61 Figure 4.1: Existing and Proposed Pulp Mills in Indonesia, as of 1997

62 and North Sumatra (see Figure 4.1). These mills have paper and board mill in southern China that will a combined production capacity of 1.1 million tonnes produce 300,000 tonnes per year (APRIL 2000). per year (APRIL 2000). Since the mid-1990s, Raja During the late 1990s, two of Indonesia’s largest Garuda Mas/APRIL has taken steps to integrate its timber sector conglomerates entered the pulp industry pulp mills with paper production facilities. The group with the aim of producing bleached hardwood kraft brought online its first paper production at RAPP in pulp (BHKP) that would be sold rather than processed 1998, and output was scheduled to reach 300,000 internally. Kiani Kertas, a fully owned subsidiary of the tonnes by the year 2000. Through a strategic Bob Hasan Group, developed a pulp mill in East partnership with the Finnish-based multinational UPM- Kalimantan that has the capacity to produce 525,000 Kymmene, APRIL has also taken steps to develop a tonnes per year (Kenny 1997). When the mill came

Table 4.1: Annual Pulp Production and Roundwood Consumption of Indonesia’s Pulp Industry, 1987-2000, with Projections for 2005 and 2010.

Year Pulp Production Roundwood Pulp Production Roundwood Capacity Processing Capacity (‘000 tonnes/yr) Consumption (‘000 tonnes/yr) (‘000 m3 sob/yr) (‘000 m3 sob*) ______1987 515 2,524 325 1,593 ______1988 606 2,969 368 1,805 ______1989 706 3,459 461 2,261 ______1990 1,000 4,900 697 3,415 ______1991 1,100 5,390 850 4,165 ______1992 1,100 5,390 870 4,263 ______1993 1,335 6,540 900 4,410 ______1994 2,055 10,068 1,314 6,439 ______1995 2,629 12,880 2,022 9,908 ______1996 2,741 13,431 2,561 12,549 ______1997 3,900 19,110 3,048 14,984 ______1998 4,300 21,070 3,430 16,807 ______1999 4,600 22,540 3,400 16,660 ______2000 4,900 24,010 4,140 20,286 ______2005 6,400 31,360 5,790 28,945 ______2010 7,200 35,280 6,715 33,605

*sob- stripped of bark Sources: APKI 1997 and Spek 2000b for 1987-2000 figures; Jaakko Poyry (1998) for 2005 and 2010 projections

63 online in early 1998, the company’s stated aim was to and to 35.3 million m3 in 2010. Assuming that the export up to 95 percent of its product to Asian, North industry were to operate with a capacity utilization rate American, and European markets. In early 2000, PT of 90 percent or higher through this period, the Tanjung Enim Lestari—a joint venture among the consumption of pulpwood by Indonesian producers Indonesia’s Barito Pacific Group, a consortium of has been projected to reach 28.9 million m3 in 2005 Japanese investors, and a holding company owned by and 33.6 million m3 at decade’s end (Jaakko Poyry former President Suharto’s eldest daughter— 1998). completed construction on a pulp processing facility in South Sumatra that has the capacity to produce Development of Pulpwood Plantations 450,000 tonnes per year (Bell 1997). Under the terms Since the late 1980s, the Indonesian government has of the partnership, Tanjung Enim Lestari’s mill is promoted the development of HTI plantations with the operated by Nippon Paper Industries, while Japan’s stated aim of establishing a sustainable source of fiber Marubeni Corporation and Cellmark of Sweden have for the nation’s rapidly growing pulp industry agreed to purchase the pulp produced for the first 10 (Groome Poyry 1993). As detailed in chapter 2, the years of the mill’s operation. government has done so by allocating large tracts of conversion forest to each of the country’s major Growing Demand for Pulpwood Fiber producers, as well as to several prospective investors The pulp industry’s ten-fold increase in output in the pulp and paper subsector. HTI license-holders between 1988 and 2000 entailed a rise in annual are permitted to clear-cut their concession areas, and pulpwood consumption from 1.8 million m3 to 20.3 to use the wood generated from such harvests until million m3 (see Table 4.1). Aggregate wood the plantations are fully online. To date, the Forestry consumption by Indonesia’s pulp industry during this Department has distributed 23 pulpwood plantation period amounted to 120 million m3.3 Prior to the crisis, licenses covering an aggregate area of 4.3 million ha industry analysts projected that Indonesia’s pulp (see Table 4.2). Thirteen of these, accounting for 2.9 production capacity would climb further to 6.4 million million ha, have been designated as “priority” HTIs, tonnes per year by 2005 and to 7.2 million tonnes per making them eligible for an expedited approval year by 2010 (Jaakko Poyry 1998). These projections process and access to subsidized financing from the imply that the volume of roundwood that the industry government’s Reforestation Fund. is capable of processing on an annual basis would rise In developing their HTIs, Indonesian plantation from 24.0 million m3 in 2000 to 31.4 million m3 in 2005 companies have utilized a number of fast-growing pulpwood species. The most promising have been 3 These figures are based on the assumption that 4.9 m3 of roundwood (green Acacia mangium, Acacia crassicarpa, and to lesser wood over bark) are needed, on average, to produce each air-dried metric tonne (Adt) of pulp. This figure is derived from Jaakko Poyry (1998), which calculates extent Gmelina arborea and Eucalyptus deglupta. conversion rates for mixed tropical hardwoods (MTH) of 4.84 m3 per Adt of pulp Of these, the dominant species utilized has been A. in the mill and 5.36 m3 per Adt pulp, standing volume in the forest. Likewise, mangium Jaakko Poyry calculates a conversion rate for plantation-grown Acacia mangium of , which accounts for approximately 80 5.01 m3 per Adt pulp in the mill, and 5.38 m3 per Adt pulp, standing volume in percent of the total area planted thus far (Jaakko the forest. The figure of 4.9 m3 per Adt has been derived by averaging the in-mill Poyry 1998). Pulpwood producers have chosen A. conversion rates of MTH and Acacia.

64 Table 4.2: Location, Affiliation, and Area of Priority Pulpwood Plantations, January 1999

Province Company Name Group Total Area Area Planted (ha) (ha) ______Aceh Tusam Hutan Lestari Bob Hasan 175,000 23,706 ______Aceh Nusa Indrapuri Takengon 166,500 29,946 ______North Sumatra Inti Indorayon Utama Raja Garuda Mas/APRIL 269,060 48,553 ______Jambi Wirakarya Sakti Sinar Mas/APP 269,580 60,923 RiauArara Abadi Sinar Mas/APP 300,000 160,209 ______Riau Andalan Raja Garuda Mas/APRIL 280,500 83,759 ______South Sumatra Musi Hutan Persada Barito 300,000 200,155 ______South Kalimantan Menara Hutan Buana Mercu Buana 186,300 79,452 East Kalimantan ITCI Hutani Manunggal ITCI 191,800 87,294 Surya Hutani Jaya Astra 198,000 110,283 Tanjung Redeb Hutani Bob Hasan 180,900 68,569 ______Adindo Hutani Lestari Adindo 201,000 27,097 West Kalimantan Finnantara Intiga Enso/Gudang Garam 200,700 29,189 ______Total 13 Priority HTI-Pulp Projects 2,919,340 1,009,135 ______Total 10 Non-Priority HTI-Pulp Projects 1,405,186 35,236 ______Cumulative Total 4,324,526 1,044,371

Source: MOFEC 1999. mangium for its rapid growth, high pulp yields, and years, the average volumes harvested from the sites ability to thrive in a wide range of ecological generally have been in the range of 112 to 150 m3/ha. conditions, including degraded and heavily leached These low yields were largely caused by the planting of soils. poor genetic material; inappropriate site preparation; Over the past decade, the productivity of A. planting in areas with compacted soils; lack of mangium has increased steadily, as Indonesian diligence in weed control; and less than optimal plantation companies have used improved planting plantation management once the trees were planted. stock and employed better management practices at Following improvements in each of these areas, their HTI sites. Areas planted in the late 1980s and most plantations of A. mangium initiated since the early 1990s, for instance, generated a mean annual mid-1990s have reportedly generated estimated mean increment of only 15 to 20 m3/ha/year, well below the annual increments (MAI) of 20 to 25 m3/ha/year, levels initially anticipated by the industry (Jaakko which should provide an average yield at harvest of Poyry 1998). With a rotation period of seven to eight 150 to 190 m3/ha (Jaakko Poyry 1998). The ability to

65 obtain such yields every seven to eight years steadily over the ensuing decade, reaching 9.7 million represents a critical element in Indonesian producers’ m3 in 1995 and 12.5 million m3 in 1999.8 The aggregate competitive advantage over their counterparts in the volume of MTH consumed by the pulp industry during North American and Scandinavian (Norscan) pulp- 1988-1999 totaled 92 million m3. If it is assumed that, producing countries. Most Norscan producers rely on on average, producers are able to obtain 110 m3 of pulpwood species such as birch, spruce, and pine, pulpable wood from each hectare they clear, then which generally require at least 20 to 25 years per consumption of MTH on this scale implies that harvesting cycle (PT Indah Kiat 1999). Indonesia’s Indonesia’s pulp industry has accounted for approx- major producers claim that, in fact, they have already imately 835,000 ha of deforestation over the past 12 raised their mean annual increments to 25 to 30 years. It is notable that virtually all of this area was m3/ha/year through further improvements in both the cleared to supply wood to four large mills; and that a genetic materials and silvicultural practices, and are single mill—Indah Kiat Pulp & Paper owned by Sinar now expecting average per hectare yields of 190 Mas/APP—accounted for over one-third of the total to 225 m3/ha for new areas planted. Their ability to area deforested. generate such yields on a large scale, however, A major factor encouraging pulp and paper remains to be seen. producers to invest in new processing capacity without first bringing plantations online has been the Reliance on Unsustainable and Illegal Fiber Supplies Indonesian government’s readiness to make large In spite of the technical improvements in plantation tracts of forest available for clear-cutting. Since the management that have occurred over the past decade, Ministry of Forestry initiated the HTI program in the the development of HTI pulpwood plantations in 1980s, it has allowed license-holders to use at minimal Indonesia has lagged far behind the expansion of cost the trees cleared from their plantation sites, under processing capacity in the nation’s pulp and paper a wood utilization permit (Izin Pemanfaatan Kayu, industries (Cossalter 1998). All of Indonesia’s pulp mills have been installed several years before 4 In publishing these figures, the Ministry of Forestry and Estate Crops provides no supporting plantations have come online, with the indication of the current condition of the areas planted at each HTI site. It would appear, for instance, that they have not been adjusted to account for the 100,000 single exception of PT Tanjung Enim Lestari’s pulp ha of planted area that are estimated to have been heavily damaged or destroyed plant in South Sumatra.5 Of the 100 million m3 of wood by the fires of 1997-1998 (Grahame Applegate, CIFOR, personal communication). 5 Tanjung Enim Lestari’s distinction in this regard probably had less to do with the that pulp producers consumed between 1988 and 1999, company’s concern for establishing a sustainable fiber supply before initiating less than 8 million m3 was sourced from plantations.6 processing operations than it did with the timing of the mill’s financing. Initially Because the increases in processing capacity have scheduled for construction in the early 1990s, Tanjung Enim Lestari encountered several delays in securing offshore financing for the project, and the mill did not far outpaced HTI development, all of Indonesia’s pulp come online until late 1999. producers have until now been highly dependent on 6 These figures, as well as those in the following paragraph, are derived from the pulpwood consumption figures presented in Table 4.1 and estimates of HTI yields mixed tropical hardwoods (MTH) obtained through presented in Jaakko Poyry (1998). clearing of natural forest. In 1988, MTH made up all of 7 See fn 5. 8 These figures are obtained by subtracting the estimated harvest volumes of the 1.8 million m3 of wood consumed by the industry.7 plantation-grown pulpwood cited in Jaakko Poyry (1998) from the overall volumes The volume of unsustainably harvested wood grew of pulpwood consumed by the industry during these years (see Table 4.1).

66 Figure 4.2: Sources of Wood Consumed by Indonesia’s Pulp Industry 1994-1999

18,000,000

16,000,000

14,000,000 Undocumented 12,000,000 Import 10,000,000 HTI/Plantation 8,000,000

6,000,000 IPK/Clear Cut

4,000,000

2,000,000

Volume Source Departemen Kehutanan (1999). Data for 1998-99 are preliminary. Year 1994/95 1995/96 1996/97 1997/98 1998/99

IPK) (Departemen Kehutanan and PT Herzal planted for this volume of fiber to be supplied on a Agrokarya Pratama 1991). Through the 1990s, the sustainable basis. The fact that the Indonesian Ministry has also made available IPK permits for the government has allocated roughly four times this area clearing of large forested areas slated for conversion to to pulpwood plantation companies suggests that the oil palm and other estate crops. The government’s HTI program is motivated by a desire to make large stated rationale for doing so has been to provide a volumes of MTH available to pulp producers, temporary “bridging supply” of wood to pulp producers regardless of whether the areas cleared are ever until their plantations are fully operational (Manurung actually replanted.10 and Kusumaningtyas 1999).9

A point that has generally been overlooked, however, 9 It bears mentioning that the author does not view clear-cutting natural forest to is that the 4.3 million ha (gross) that the Ministry has provide a ‘bridging supply’ of fiber to Indonesia’s emerging pulp industry to be, a priori, a negative development. Indeed, many would argue that the conversion of allocated for pulpwood plantations vastly exceeds the natural forest to pulpwood plantations is a legitimate strategy to provide a area that Indonesia’s pulp industry would actually need launching pad for a competitive industry. What is important to recognize, however, is that the Indonesian government has allocated to the pulp industry an aggregate if it were to be run sustainably. If it is conservatively area of natural forest that well exceeds the industry’s fiber needs if it were to pursue assumed that HTIs will generate average yields of 150 an efficient plantation development program. Moreover, a handful of very large-scale actors have until now enjoyed the vast majority of the benefits that have derived m3/ha/year, then it can be estimated that 133,000 ha from the government’s forest conversion policy. per year would need to be harvested to provide the 20 10 It should be acknowledged that in many HTI concession sites, the net plantable million m3 of wood that the pulp industry consumes area is limited to 60 to 70 percent of the total area allocated. If this ratio is applied to the 4.3 million ha that the government has assigned to pulpwood plantation annually at its current production level of 4.1 million companies, it implies that between 2.6 and 3.0 million ha are plantable. These tonnes per year. An eight-year harvesting cycle would areas are still considerably greater than the 1.1 million ha that are presumably needed to meet existing industry demand on a sustainable basis. imply that just under 1.1 million ha would need to be

67 Although the pulp industry’s major producers are from now. Right now, our HTIs are essentially an now actively engaged in developing plantations on a insurance policy, and we will cash it in when the considerable scale, there are compelling reasons to MTH is no longer available.11 believe that they will continue to rely on large volumes In addition to the large volumes of legal but of mixed tropical hardwoods for as long as they are unsustainably harvested wood that have been cut by able to do so. MTH is, by any measure, an extremely IPK license-holders, a substantial volume of fiber low-cost source of fiber under Indonesia’s current consumed by Indonesia’s pulp industry has come from forest royalty regime, which requires the payment of a undocumented sources. Industry statistics indicate reforestation fee of US$2 per m3 (payable in rupiah at a that the country’s pulp mills processed approximately rate of 5,000 to the US dollar) and a royalty of Rp 2,000 50 million m3 of wood during the period between 1994 per tonne (Spek 2000a). MTH is particularly cheap and 1999 to produce 10 million tonnes of pulp. when pulp producers are able to obtain their wood According to Indonesian government figures, 28 from concession areas under the control of affiliated million m3 of this originated from areas covered by companies. Both Indah Kiat and Riau Andalan Pulp & IPK licenses, just under 1.3 million came from HTIs, Paper, for instance, have been able to secure the bulk and a small amount was imported in the form of wood of their raw materials from affiliated HTI license- chips (see Figure 4.2).12 While these figures are far holders at a price that is equal to the actual cost of from conclusive, they suggest that Indonesian pulp harvesting and delivering the wood to the mill, along producers may have obtained as much as 20 million with the payment of government royalty fees m3—or 40 percent of the wood they consumed during (Ausnewz 1999). this period—from illegal sources. Some industry officials have suggested that In interviews, several industry executives acknowl- Indonesia’s two largest pulp producers see substantial edged that the use of illegally harvested wood is capital investments in plantations, by comparison, as common practice among the nation’s pulp producers. being financially burdensome: not only do they place Some indicated that their mills regularly purchase a constraints on the group’s liquidity over the seven to substantial portion of the wood they process without eight year rotation period, but they also entail a knowing its provenance. According to one company’s considerable degree of risk. A financial officer at one wood supply manager, “Our concern is to keep our of these groups summed up his company’s wood mill running. When we buy wood, why should we care supply strategy as follows: where it comes from as long as the price is reason- Of course we are bringing our plantations online. able? Whether or not it was harvested illegally, that is But we’re in no rush to switch our mill to acacia if the Forestry Department’s responsibility [to there are still cheap supplies of mixed tropical monitor].”13 In some cases, pulp producers are hardwoods (kayu campuran) available. Why should 11 Confidential interview, Jakarta, December 8, 1999. we be? As it stands, we have access to a very low-cost 12 It should be noted that these figures are, in fact, quite conservative. supply of raw materials. Developing good plantations They do not take into account the fact that at least a portion of the wood harvested under IPK licenses was processed for lumber or wood panels. not only involves higher costs, but also a good deal of Typically, IPK holders will send logs that are 30 cm and up to sawmills or risk—the trees have to be there for harvest seven years plywood mills, while the smaller diameter wood is utilized for pulp fiber.

68 reported to purchase wood from harvesting teams sites (PT Indah Kiat 1999; APRIL 2000). that are illegally logging within those companies’ own However compelling these projections may seem, concession sites.14 These companies reportedly finance there are at least four significant reasons to believe such illegal logging operations not only to circumvent that they could prove to be overly optimistic. First, the payment of royalty fees on the wood harvested, but there are widespread allegations within the industry also to secure use of the wood before it is cut by other that Indonesian plantation companies have regularly actors seeking to establish control over the land. overstated the size of the areas planted and anticipated growth rates in order to inflate their projected yields. Projected HTI Yields and Potential Shortfalls As will be discussed below, recipients of plantation In spite of the slow pace of HTI development thus subsidies from the government’s Reforestation Fund far, many industry analysts anticipate that the volumes have frequently been motivated to do so in order to of pulpwood produced in plantations will expand obtain higher grant allocations and discounted exponentially over the next several years. International financing than they would otherwise be entitled to forestry consulting firm Jaakko Poyry, for instance, (Ernst & Young 1999). While neither the Sinar has projected that by 2003, aggregate yields from HTIs Mas/APP nor the Raja Garuda Mas/APRIL groups has would quadruple from 1999 levels to reach 17 million drawn on DR funds to support its plantation m3, or approximately 70 percent of the industry’s development efforts, both groups have nonetheless anticipated fiber demand for that year (Jaakko Poyry had strong incentives to maintain the image that they 1998). HTI yields are thereafter projected to rise to 32 are solidly on schedule in meeting what are, by any million m3 in 2009, when they are expected to provide measure, ambitious planting targets. Indeed, both 95 percent of the pulp industry’s raw material supply. groups obtain much of their investment and working Formulated in 1998, these projections were apparently capital through equity and bond issues, and therefore based on the aggressive planting schedules that the each relies heavily on investor confidence in the industry’s two largest producers, the Sinar Mas and company’s ability to generate low-cost fiber on a Raja Garuda Mas conglomerates, had followed through sustainable basis. Perhaps for this reason, both groups the previous year. In 1997, the two groups’ annual are extremely cautious about divulging the details of planting programs are reported to have planted 27,000 their annual planting programs and the relative growth and 28,000 ha, respectively, at their Riau plantation of each year’s tree stock as it moves through its

15 13 Confidential interview, Jakarta, December 8, 1999. rotation. This makes it extremely difficult for 14 The wood supply manager for one of Indonesia’s major pulp producers industry observers to estimate with confidence actual explained in an interview that his company regularly purchased 40 percent of the areas planted at these companies’ concession sites and wood that its mill consumes. He said that the mill often finds it cheaper to buy wood from locals illegally harvesting wood within the company’s concession area what volumes of wood these areas can be expected to than from the firm’s own contractor because the former do not require payment of yield. The critical point is that for Indonesia’s HTI government royalties. To facilitate such harvesting, the company reportedly provides illegal logging teams with chainsaws. Much of this harvesting is done at night, while 15 In their annual reports and Form 20-F filings with the US Security and the contractor’s formal logging operations are carried out during the day. When Exchange Commission, neither Sinar Mas/APP nor Raja Garuda Mas/APRIL asked what his company would do when MTH stocks at its concession site were reports annual areas planted on a year-by-year basis. Nor do they identify depleted, the informant expressed little concern, explaining that “There’s still lots of seedling densities in specific planting blocks or areas where planted trees have protected forest [Hutan Lindung] available!” Confidential interview, Jakarta, failed. Instead, they generally limit their reporting to aggregate figures of total December 8, 1999. planted area at their plantation sites.

69 plantation program to generate the volumes of species and, therefore, requires harvesting and pulpwood fiber that have been projected, an adequate replanting operations to be carefully timed. Many number of hectares will need to be planted seven to industry sources are confident that new silvicultural eight years before the expected harvest; these planted technologies will be adapted to address each of these areas will need to be fully stocked; and the trees problems as it arises. Some, however, have quietly planted will need to be available for harvest when the speculated that Indonesia’s plantation companies may rotation is complete.16 only be able to maintain yields beyond the second The fact that plantations of fast-growing tree species rotation by developing new HTI sites and/or by are potentially vulnerable to a range of technical prob- adopting new genotypes over time. lems represents a second reason that the abovemen- Fires are a third factor that could keep Indonesia’s tioned HTI projections may prove to overestimate pulpwood plantations from generating the yields that actual yields.17 A critical challenge facing many HTIs is have been projected. Indeed, the catastrophic fires of that they are being developed on areas with fragile soil 1997-1998 are estimated to have destroyed approxi- structures (e.g., peat or impoverished mineral soils), mately 100,000 ha of planted HTIs in Kalimantan and which can degrade rapidly under the high-frequency Sumatra (Asian Development Bank 1998).19 Acacia and logging regime that a seven to eight year harvesting Eucalyptus plantations are particularly susceptible to rotation implies (Ausnewz 1999). To maintain yields fire as their leaves have a high oil content. Trees that across several rotations, companies will need to utilize are three years of age and younger are the most harvesting methods that minimize soil loss and vulnerable, as their thin bark is not yet fire-resistant.20 compaction. At some sites, pests, fungus, and disease Moreover, the proliferation of low-level branches often have already emerged as problems after the second helps to carry fire from grassy understory to the planting, and there is reason to believe that these crowns of the trees. This frequently gives added will become even more serious during subsequent intensity to a fire, turning what may start as a low-level rotations.18 This is particularly the case for Acacia burn into a high-intensity blaze once it enters a mangium, which does not coppice like most Eucalyptus plantation site. It should also be noted that most Indonesian plantation companies have poor fire 16 Since the onset of the financial crisis, for instance, there have been dramatic cuts in planting at most HTI sites. The areas planted at the Sinar Mas/APP group’s prevention and suppression systems in place. main plantation in 1998 and 1999 are reported to have fallen by over 50 percent The prevalence of social conflict linked to pulpwood from pre-crisis levels, while those for Raja Garuda Mas are believed to have plantations presents a fourth reason that HTI yields dropped even further still (Spek 2000). These apparent slowdowns in the pace of planting will clearly have a significant impact on the raw materials available to the may fall short of the projections outlined above. Such industry’s major producers in the coming years. Because pulpwood plantations conflicts have frequently arisen because HTI operate on a seven to eight year rotation, failure to plant an adequate number of hectares in 1998 and 1999 will lead to deficits in 2005 and 2006. concessions have been located on areas traditionally 17 A point of particular concern is that none of Indonesia’s pulp producers has yet owned and/or managed by local people (Fried 1995). grown A. mangium, or the other species currently being used, through a full second rotation. Indeed, the country’s first pulpwood plantations were established in 1987, 18 Christian Cossalter, CIFOR, personal communication, August 14, 2000. which means that their second harvest will not take place until 2001. At most HTI 19 This figure is based on an estimation of HTI areas burned with trees that are sites, initial planting did not occur until the early 1990s. Plantation companies, three years of age and under. Trees over three years are believed to have been able therefore, have little empirical data to indicate how these species will perform when to survive fires of moderate intensity. they are grown intensively across multiple rotations. 20 Grahame Applegate, CIFOR, personal communication, August 28, 2000.

70 In the case of PT Musi Hutani Persada’s 300,000 ha steps to consolidate control over the land in the pulpwood plantation in South Sumatra, for instance, concession allocated to them. At this point, however, it members of surrounding communities have demanded is not at all clear that either group will be able to compensation payments of Rp 25 million (US$3,000) secure the full area of land needed to meet its long- per hectare for areas that they claim have been term HTI planting targets. unjustly occupied by the company since 1991 (Nadiar 2000). Because HTI development is generally struc- FIBER DEFICITS AT THE MILL LEVEL tured to provide the plantation company with exclusive Figures 4.3 and 4.4, in the sections below, provide control over the land within the concession area for an graphic illustrations of how the projected industry-wide extended period of time, many communities have deficits of sustainably harvested pulpwood fiber are responded to the establishment of HTIs even more likely to play out at the micro-level. Based on vociferously than to the allocation of logging conces- projections of fiber supplies from pulpwood plantations sions on adat lands. In numerous cases, villagers have and from IPK forest clearing, these figures show the taken action to disrupt HTI operations, including the volumes of wood that the country’s two largest pulp use of arson and pulling up trees after they are mills—Indah Kiat and Riau Andalan Pulp & Paper—are planted.21 expected to obtain from existing legal sources during In some areas, local communities also have been the period 1998 to 2007. The two mills are located less actively competing with plantation companies for than 100 km from one another in the east Sumatran access to land in order to plant their own cash crops. province of Riau. Together, they account for roughly Industry analysts familiar with the large Sumatran 60 percent of Indonesia’s total pulp production. plantation programs have indicated, for instance, that To date, both mills have relied heavily on the use of growing numbers of smallholders have sought to mixed tropical hardwoods, much of which is obtained establish oil palm estates within the formal boundaries through the clearing of natural forest. However, each is of the HTI concessions over the last few years.22 Such now facing a sharp decline in the availability of MTH practices threaten to undermine the companies’ access as stocks are dwindling at their own concession sites to raw materials both by reducing the total volume of and increasingly small areas of forest are available for MTH that can be extracted from these sites and by conversion within a commercial distance of the two restricting the net planting area available for pulpwood mills. Both companies are actively bringing pulpwood species. Recognizing this, both companies have taken plantations online with the aim of supplying their mills’ fiber needs on a sustainable basis. Neither firm’s 21 As will be discussed later in the chapter, the threats to HTIs posed by plantations, however, will be sufficient to supply the conflicts with local communities appear to have increased significantly since the fall of the Suharto regime. During the New Order period, forestry conglomerates volume of wood needed for its mill to run at or near were rarely hindered by local communities’ opposition to their projects because the capacity at any point during the next several years. government was willing to take harsh measures to guarantee social control. (Fried 1995). Under the current administration, however, the central government is Indeed, both mills face sizeable fiber deficits over the substantially weaker and considerably less willing to use force to resolve resource coming decade. There is growing evidence to suggest conflicts between local communities and large business interests in favor of the that each will continue to rely on unsustainably latter (Campbell 1999). 22 Confidential communication, January 23, 2000. harvested wood and will be forced to purchase an

71 Own MTH Outside MTH HTI/Plantation Figure 4.3: PT Indah Kiat Pulp and Paper, Volume of Fiber by Source, 1998-2007 Pulpwood Deficit

10,000

9,000

8,000 Fiber Demand )

3 7,000

6,000

5,000

4,000 Volume (‘000m Volume 3,000

2,000

1,000

0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Year

Note: Assumes mean annual increment = 25 m3/ha/year and 7-year rotation. Area planted in 2000 assumed to be 20,000 ha. Sources: HTI figures and 1998-1999 MTH figures based on projections from data provided in Spek (2000a) and Jaakko Poyry (1998) for MTH figures. increasing portion of its raw materials from sources 15-year supply contract signed in 1994, Indah Kiat outside of Sumatra. purchases mixed tropical hardwoods harvested by Arara Abadi, at prices that amount to the cost of Indah Kiat Pulp & Paper harvesting and delivering the wood to the mill Indah Kiat is the largest subsidiary of Asia Pulp & (inclusive of government royalties). Such at-cost Paper, the Sinar Mas Group’s Singapore-based holding purchases from Arara Abadi have accounted for company. Since 1989, Indah Kiat has expanded its pulp roughly 70 percent of the wood consumed by Indah production capacity from 120,000 tonnes to 1.8 million Kiat over the past decade. The company purchases tonnes per year (APP 2001). It currently accounts for whatever remaining wood it needs from a range of 77 percent of APP’s pulp production capacity and third-party suppliers, which include IPK license appoximately 40 percent of Indonesia’s overall pulp holders that are clearing forested areas for oil palm output. In 2000, the mill consumed an estimated 8.8 and other estate crops, as well as various units of the million cubic meters (m3) of wood—or roughly one- state forestry enterprise, Inhutani IV. Typically, such third of Indonesia’s legal wood supply (APP 2001). external wood purchases entail costs that are Thus far, Indah Kiat has sourced the bulk of its raw substantially greater than those associated with materials from an affiliated company, Arara Abadi, obtaining MTH from Arara Abadi. which holds a 300,000 ha plantation concession permit Since the mid-1980s, Arara Abadi has taken steps to (PT Indah Kiat 1999). Arara Abadi’s concession area is develop a pulpwood plantation that can supply Indah disbursed among several blocks that are located 60 to Kiat’s fiber needs on a sustainable basis over the long 120 km from Indah Kiat’s Perawang mill site. Under a term. The net plantable area of the company’s various

72 concession blocks is 217,000 ha (PT Indah Kiat 1999). longer tenable, Indah Kiat recently revised its Arara Abadi carried out its first substantial annual projection to 2007(APP 2001). A detailed financial planting of A. mangium in 1987, and through 2000, the analysis prepared by Singapore-based brokerage house cumulative area planted had reached approximately GK Goh suggests that even this revised target is 180,000 ha. Annual area planted has varied consider- extremely optimistic (Spek 2000a). With the areas that ably over the past several years, ranging from a low of the company is believed to have planted thus far, the 10,000 ha in 1993 to a high of just under 27,000 ha in annual volume harvested from Arara Abadi’s plantation 1997 (Spek 2000a). Planting is believed to have slowed can be expected to grow to 1.7 million m3 in 2000 and considerably in 1998 and 1999, dropping to 18,000 ha to 4.6 million m3 in 2004. As Figure 4.3 shows, this and 11,000 ha, respectively. However, during these latter volume amounts to roughly 50 percent of the years Arara Abadi also made its first substantial har- mill’s fiber needs at that point. In 2005 and 2006, the vests from the plantation, obtaining 390,000 m3 in 1998 volume of wood coming from the plantation is expected and 900,000 m3 in 1999 (Spek 2000a). The acacia wood to drop, being that the areas planted in 1998 and 1999 harvested in 1999 accounted for 20 percent of the fiber had declined from previous years. consumed by Indah Kiat that year. The GK Goh study points out that with a net Through the 1990s, Indah Kiat regularly stated in its plantable area of 217,000 ha, Arara Abadi can plant at annual reports that the Arara Abadi plantation would most 27,125 ha if it manages the site on an eight-year supply “substantially all” of the mill’s wood require- rotation (Spek 2000a). To fully meet Indah Kiat’s fiber ments by 2004 (PT Indah Kiat 1999). This implies that needs on a sustainable basis, the plantation would have the company expected the plantation, by then, to to obtain a mean annual increment of at least 41 generate upwards of 9.0 million m3 of pulpwood on an m3/ha/yr for all planted areas. If Arara Abadi seeks to annual basis to keep the mill running at its current reduce the rotation period to six years, as Indah Kiat capacity. A simple estimation of the area actually has at times suggested, the company would need to planted at Arara Abadi and the anticipated volume plant over 36,000 ha annually, while also achieving yields suggests that Indah Kiat’s sustainability target these ambitious growth rates in order to fulfill the has been extremely optimistic. Using a seven to eight mill’s current fiber needs. year growing cycle, the trees to be harvested in 2004 In facing such substantial fiber shortfalls from would have had to be planted in 1996 or 1997. In fact, Arara Abadi’s plantation, Indah Kiat has increasingly Arara Abadi planted nearly 20,000 ha in 1996 (Spek few options for filling the deficit with cheap supplies of 2000a). However, for this area to generate 9.0 million mixed tropical hardwoods. As Figure 4.3 shows, MTH m3 of wood, it would have to produce a yield of 450 supplies at Arara Abadi and the affiliated concession m3/ha (or a mean annual increment of 64.3 m3/ha/yr). areas nearby are expected to be exhausted within the Many industry analysts conservatively estimate that next couple of years (Jaakko Poyry 1998). Moreover, Arara Abadi’s maximal yields for areas planted in 1996 analysts expect that there will be a marked decline in will be closer to 175-200 m3/ha, assuming a mean the volumes of legally harvested MTH that are annual increment of 25 m3/ha/yr. available within a commercial distance of the mill, and Recognizing that its 2004 sustainability target is no that Riau’s supplies of such wood will be exhausted by

73 2005. This implies that Indah Kiat will be facing Riau Andalan Pulp & Paper substantially higher wood costs in the near future, as it Riau Andalan Pulp & Paper (RAPP), a subsidiary of may be forced to purchase a growing portion of its the Raja Garuda Mas group’s APRIL holding company, fiber from other parts of Indonesia or possibly from began operating in 1995 and has recently passed Indah overseas. Kiat to become Indonesia’s single largest pulp mill. Indah Kiat officials have recently admitted that the The mill’s effective production capacity rose to 850,000 Arara Abadi plantation does not have adequate tonnes per year in 1999 to 2.0 million tonnes in 2001, plantable area to meet the mill’s overall fiber needs.23 when the company completed a two-phase installation However, they deny that the mill is facing a fiber of a second production line (Paperloop.com, June 1 shortfall. They claim that the company has recently 2001). secured access to 180,000 ha of degraded forests in Until now, virtually all of the mill’s fiber has been Riau, which it will manage through joint venture con- mixed tropical hardwoods obtained through the tracts with ‘cooperatives’ (APP 2001). These officials clearing of natural forest (APRIL 2000). Roughly 80 report that Indah Kiat will clear the remaining percent of this has come from the company’s 280,500 standing forests to harvest the MTH and immediately ha HTI concession site, which is located near the mill replant these areas with Acacia mangium. As of in Riau. Much of the remainder has come from an October 2001, however, Indah Kiat has provided no affiliated company’s plantation development project details regarding where these areas are located; what 400 km to the north of the mill. volumes of wood they contain; who has managed these Like Sinar Mas/APP, the Raja Garuda Mas/APRIL forests until now; what licenses have been issued to group has been moving aggressively to bring large- the company to allow them to convert these sites to scale pulpwood plantations online. RAPP reportedly plantations; at what pace they will be planted; and the has access to 195,000 ha of net plantable area at its likely wood costs involved for the mill. HTI site; 85,000 ha at plantation sites held by associated and joint venture companies; and 20,000 ha managed by nearby communities as part of an outgrower scheme (RAPP 2001). The company claims that through the end of 2000, 151,000 ha had been planted on all sites (RAPP 2001). In its 1999 annual report, APRIL projected that the company’s then-pulp capacity of 850,000 tonnes would be fully supplied with plantation wood by year 2004. Following the mill’s recent expansion to 2.0 million tonnes, the company claims that it will supply all of its fiber needs from sustainably managed plantations from 2008 onwards (RAPP 2001). The company claims that until the plantations are fully online, it will bridge the mill’s fiber 23 Mark Werren, Director APP Forest Audit, personal communication, July 22, 2001 needs with low-cost MTH obtained from areas cleared

74 for timber and oil palm plantation development and plantation program vigorously question the feasibility from sawmill and plymill residues. of these projections. There is considerable skepticism APRIL apparently bases these projections on the within the industry that APRIL has the capacity to assumption that in 2004, it will be able to harvest orchestrate the planting of 48,000 ha as early as 2001 27,800 ha of acacia plantations that were reportedly and to maintain annual planting rates at 45,000 ha each planted in 1997.24 To generate the 4.3 million m3 of year thereafter. Expansion on this scale would wood that would be needed to produce 850,000 tonnes effectively amount to a 150 percent increase in the of pulp, these areas would need to show an average annual areas planted at both RAPP’s own HTI and growth rate of 22 m3/ha/year over a seven-year affiliated sites, as compared to 2000 levels. The sheer rotation. Industry analysts familiar with the company’s logistics of planting such a large area on an annual plantation program have confirmed that a mean annual basis are complicated by the fact that planting must increment on this order is a reasonable estimation of follow land clearing in close sequence in order to avoid average growth rates for areas planted at RAPP’s HTI the invasion of imperata grass. Moreover, some site over the past several years. This would suggest, analysts have expressed concerns regarding the fact then, that the company’s ability to meet its plantation that APRIL’s projections are based on an assumed target for 2004 will largely depend on whether the mean annual increment of 30 m3/ha/year, claiming company actually planted the total area reported, that growth rates across such a large area are likely to whether the areas planted are fully stocked, and be closer to 25 m3/ha/year for areas now being whether these areas are available to the company planted.27 APRIL’s mean annual increment projections when it is time for harvest. 24 APRIL’s 1999 annual report indicates that RAPP planted approximately 18,000 APRIL’s longer-term plantation projections are far ha in 1997 at its own HTI site, and that affiliated companies and joint ventures planted roughly 10,000 ha. An additional 1,000 ha was reportedly planted by more difficult to reconcile. The company claims that its community out-growers. In 2001, the company reduced its estimation of the total plantation program will generate 9 million m3 per year area planted in 1997 to 27,800. 25 It should be noted that APRIL assumes that 4.5 m3 of wood will be needed to by 2008 (RAPP 2001). It further maintains that this produce each tonne of pulp. Other sources (e.g., Jaakko Poyry 1998) have placed volume of fiber would be more than sufficient to meet the conversion ratio at 4.9-5.1 m3 of roundwood (greenwood over bark) per tonne RAPP’s raw material needs at the mill’s current of pulp, depending on whether plantation acacia or MTH is used. If this higher conversion ratio is used, it would imply that RAPP will need approximately 10 25 capacity of 2.0 million tonnes per year. APRIL’s million m3 of wood to run its mill at 2.0 million tonnes per year. strategy for achieving such a sharp rise in the volume 26 In its 1999 annual report, the company projected that the annual area planted would climb from 27,000 ha in 1998 to 58,000 ha in 2001 (APRIL 2000). of plantation wood harvested involves a massive Thereafter, the annual area planted at all sites was projected to average 50,000 ha increase in the annual area planted at both its own and through at least 2012. If it is assumed that the net plantable area at all plantation affiliated HTI sites. The company currently projects sites is 300,000 ha, then planting at this pace would also imply that these sites are going to be managed on a six-year rotation. While RAPP and some other that the annual area planted at all sites will climb from companies have reported being able to obtain adequate yields on limited areas of 18,730 ha in 2000 to 37,000 ha in 2001 and to 48,000 in acacia plots when harvested at six years, this is well below the industry average of seven to eight years. Plantation experts interviewed for this study generally agree 2002 (RAPP 2001).26 Thereafter, the total area planted that it is highly unlikely that an area as large as 300,000 ha can successfully be at all sites is projected to remain above 45,000 ha per managed under such an abbreviated rotation within the next several years. To plant year at least through 2020. at a rate of 50,000 ha per year over a seven to eight year cycle, RAPP would need a net area of 350,000—400,000 ha, or 17 to 33 percent more land than it Industry analysts who are familiar with RAPP’s currently claims to have access to.

75 Own MTH Outside MTH HTI/Plantation Figure 4.4: PT Riau Andalan Pup and Paper, Volume of Fiber by Source, 1998-2007 Pulpwood Deficit

10,000

9,000

8,000 Fiber Demand

7,000 )

3 6,000

5,000

4,000

Volume (‘000m Volume 3,000

2,000

1,000

0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Year

Note: Assumes MAI = 25 m3/ha/year and seven-year rotation. Sources: HTI and fiber demand figures derived from data provided by APRIL (2001); MTH figures from Jaakko Poyry (1998).

would appear to be particularly optimistic for areas Moreover, it is assumed that legally available sources that are to be managed through joint ventures and out- of mixed tropical hardwood will be exhausted at grower schemes, and will not therefore be under the RAPP’s concession and site by 2005. company’s direct management. Based on the assumptions described, the volume of Figure 4.4 presents an alternative scenario for Riau fiber that RAPP obtains from plantation-grown Andalan Pulp & Paper’s fiber sourcing for the period pulpwood is projected to rise from 944,000 m3 in 2001 1998-2007, based on a more conservative set of to just under 5.0 million in 2004. At that point, assumptions than those used by APRIL. Specifically, plantation-grown acacia will supply roughly 50 percent the data presented assume that RAPP manages its of the mill’s total fiber needs. In the years that follow, plantation areas according to a seven-year harvesting however, the portion of the mill’s fiber that comes from cycle and that the average growth rate across all HTIs is projected to decline. By 2007, it is anticipated planted areas is 25 m3/ha/year for a yield of 175 that the company’s plantations will supply roughly 32 m3/ha. It is assumed that APRIL planted 27,800 ha in percent of the 10 million m3 of fiber then expected to 1997; 22,400 ha in 1998; 24,700 ha in 1999; and 18,700 be consumed by the mill. Although the company has ha in 2000, as it claimed, and that all of these areas will claimed that it would rely on bridging supplies of MTH be available for harvest at the end of the rotation. to supply the mill with whatever volumes of fiber cannot be sourced from plantations, there are strong 27 One reason for this is that much of the areas now being planted by RAPP are indications that legal supplies of MTH within a on peat soils, which are unlikely to produce 30 m3/year over multiple rotations (confidential communication with plantation industry expert, August 28, 2000). commercial distance from the mill will be substantially

76 diminished, if not exhausted, by 2005 (Jaakko Poyry The development of pulp and paper mills on the 1998). This suggests that APRIL will increasingly be scale that has occurred in Indonesia has required very forced to obtain wood from outside of Sumatra, which substantial allocations of investment capital. Greenfield will entail considerably higher raw material costs than mill projects typically require investments of between it has paid until now. US$1,000 and US$2,000 per tonne of processing capacity (Spencer and Choi 1999). As such, Indonesia’s LARGE CAPITAL INVESTMENTS AND largest pulp and paper projects have cost between HIGH LEVELS OF FINANCIAL RISK US$600 million and US$1.3 billion apiece, while new The exponential growth of Indonesia’s pulp and paper production lines at existing mills have cost one-quarter industries over the past decade has been led by the to one-third of this. It is estimated that the increase in development of a relatively small number of mills with Indonesia’s pulp and paper processing capacity since very large processing capacities. Whereas most paper the late 1980s has involved total investments of at least machines installed through the late 1980s were gener- US$12 billion.28 ally capable of producing no more than 50,000 tonnes The high fixed costs associated with pulp and paper per year, several of those purchased by Indonesian projects generally means that mills are only companies since the mid-1990s have production economical if they are run continuously at or near capacities of 300,000 tonnes or more (Spencer and capacity. In Indonesia and elsewhere, most pulp and Choi 1999). Likewise, the country’s four major pulp paper producers seek to keep their mills running 24 producers had brought online processing facilities that hours per day for 51 weeks out of the year, with the were able to generate at least 450,000 tonnes per year. remaining week scheduled for general maintenance Each of these ranks among the largest processing and debottlenecking.29 Heavily leveraged mills that are facilities of its kind in the Asia/Pacific region. unable to operate near capacity often have difficulty The most commonly stated rationale for this staying current on their outstanding financial emphasis on mega-projects has been that pulp and obligations. In this context, it is clear that Indonesian paper investors are eager to take full advantage of the pulp and paper producers have assumed a high degree low production costs available in Indonesia (Hill 1998). of financial risk by developing large-scale processing Historically, pulp and paper have both been highly facilities without first securing a legal and sustainable cyclical commodities, with heavy shifts in world fiber supply. The substantial risks associated with demand leading to sharp upswings and downturns in heavy investments in processing expansion, given raw market prices. By investing in large-scale processing material uncertainties, are highlighted in a 1999 facilities, Indonesian producers have sought to estab- industry study: lish economies of scale that would allow them to remain profitable even during protracted market 28 This is based on the conservative assumption that the average cost per tonne of down cycles. processing capacity (new mills and additional lines) in both the pulp and paper industries was US$1,100. 29 The term “debottlenecking” refers to the process of making technical changes in a mill’s production process so as to remove inefficiencies that might keep the mill from operating at full capacity.

77 In opting for such headlong expansion in capacity, environmental perspective, such purchases would the companies appear to have subscribed (or over- likely extend to those islands the pressures that these subscribed) to the continual extrapolation of the large mills have until now exerted on the natural consultants’ proposition that the only safe way to invest forests of Riau. Financially, the transport of pulpwood in pulp capacity is to build the mill so big that it is chips over several hundred kilometers would raise the always on the lowest part of the capital and operating mills’ operating costs quite considerably from their cost/tonne curve. This is an enviable situation to be in, present levels. Indeed, some industry analysts have provided the funds continue to flow to support such argued that both mills would face logistical difficulties massive expansions. Prodigious volumes of wood are, bringing in large volumes of wood being that they are however, required and there would be few locations on located approximately 50 km upriver, and the rivers earth capable of supporting such massive capacity are shallow.30 As discussed in subsequent sections, without extensive and successful prior planting... In such cost increases would pose serious concerns for Indonesia at the present time, the folly of proceeding with investors due to the fact that these mills are now large pulping developments without a pre-established carrying heavy debt loads and will soon be facing wood supply is being demonstrated by the very large higher-than-normal tax burdens (Spek 2000a). amount of wood that is having to be brought in from It is also possible that Indonesia’s largest mills increasingly distant locations over roads that are rapidly would seek to obtain plantation-grown fiber from deteriorating, with little prospect of adequate repair Australia, Thailand, Malaysia, or other countries in the (Ausnewz 1999). region. However, in addition to the distances involved, The large mills run by Sinar Mas/APP and Raja importing chips would force these companies to pay Garuda Mas/APRIL may seek to ship in pulpwood world market prices for their wood, which are several fiber from outside Sumatra once MTH supplies in Riau times higher than domestic rates. An Australian wood and surrounding provinces are exhausted. By boat, chip exporter, for instance, recently estimated that at wood chips can often be transported economically over November 2000 prices, the anticipated cost for the great distances. Japanese pulp producers, for instance, Sumatran mills to import plantation-grown eucalyptus import nearly 25 million tonnes of pulpwood chips per chips from Tasmania would run as follows: 1) US$75- year from 16 countries, including such distant locales 80 Freight on Board (FOB) per bone dry tonne; 2) as Chile and the southern United States (International US$30 per bone dry tonne for freight; 3) 25 to 30 Woodfiber Report 1998; Jaakko Poyry 1997). This raises percent of freight charges in discharging fees important questions about where, and at what cost, (depending on the port). Added up, this suggests that Indonesian pulp producers might be able to obtain fiber when natural forests within commercial distance 30 Confidential interview with an Australian wood chip exporter, November 20, from the large mills can no longer supply their needs. 2000. According to this exporter, it is not possible to get a full-size chip boat up the Siak or Kampar rivers to Indah Kiat or RAPP,so the chips would have to be To the extent that Indah Kiat and RAPP seek to transferred to smaller barges -- which would still have a challenge getting up to the purchase chips from outside Sumatra, there is a strong mills. In the case of RAPP,the mill is located some distance from the river, so the chips would have to be transported by truck from wherever they are landed. He likelihood that they would source this fiber, at least noted that this is all in sharp contrast to the Japanese chip importers, which have initially, from Kalimantan and West Papua. From an their mills located right along the coast so as to minimize transfer costs.

78 APP and APRIL would need to pay approximately capital subsidies for pulp and paper projects, which US$120 per bone dry tonne, which is equivalent to have enabled producers to sharply discount their about US$60 per green tonne of chips—or roughly investment and production costs.32 These subsidies three to four times what the mills are currently paying have included the provision of cheap raw material to source MTH from their own concessions in supplies, discounted loans from state-owned banks, Sumatra. Moreover, imports would require Indonesian allocations from off-budget pools of finance, as well as producers to use hard currency to secure a substantial generous tax deductions. During Suharto’s New Order portion of their raw materials, thereby undermining a period, senior officials often disbursed these subsidies significant cost advantage that they have enjoyed until in a discretionary manner, providing firms linked to now. state elites with benefits well beyond those allocated to With growing demand among Northeast Asian pulp producers without such ties. producers, some analysts have also projected that the In addition to providing direct capital subsidies to Pacific Rim wood chip trade is likely to become sharply pulp and paper producers, the Indonesian government more competitive in the coming years, leading to has indirectly subsidized investments in each of these stepped-up prices over the medium to long term industries through the weak regulation of the nation’s (International Woodfiber Report 1998; International financial system. Most of Indonesia’s major pulp and Woodfiber Report 1996).31 paper companies are owned by large conglomerates with investments in a range of other sectors, several of GOVERNMENT SUBSIDIES AND which control their own banks. In the years leading up WEAK FINANCIAL REGULATIONS to the financial crisis, the government regularly failed To a significant degree, Indonesian pulp and paper to enforce its own laws in the commercial banking producers have been motivated to invest large amounts sector, particularly when they threatened to constrain of capital in high-risk projects because much of the the lending practices of banks owned by groups with costs involved have been borne by others. In particular, ties to state elites. Indonesia’s largest pulp and paper the Indonesian government has provided substantial producers have taken advantage of this weak regulatory environment to obtain large sums of finance

31 The Australian chip exporter interviewed indicated that it would be a few years well below commercial lending rates. They have done before that country’s chip market could absorb the anticipated demand for chips so most significantly through the allocation of related- from Indah Kiat and RAPP.Currently the Australian chip industry generates 1.5—2.0 million green tonnes of hardwood chips. He said that it would be 2007 or 2008 party loans above the government’s legal lending before the industry could easily absorb an additional demand of 4 million tonnes limits, the misappropriation of central bank liquidity or so (Indah Kiat’s projected shortfall). His sense was that the companies would be credits, and the use of financial mark-up schemes. looking to bring wood in from Kalimantan if they were able to do so. Confidential interview, November 20, 2000. 32 It should be noted that subsidies are not intrinsically perverse. Indeed, Cheap Raw Material Supplies governments in most countries routinely use subsidies to encourage investment in strategic industries or sectors that provide socially-desirable goods or services, such Access to cheap supplies of pulpwood fiber is arguably as transportation or education. The critical point in the sections that follow is not to the most significant factor motivating the heavy condemn subsidies to Indonesia’s pulp and paper industries as such, but rather to emphasize the role that government subsidies have played in encouraging the investments made in Indonesia’s pulp and paper country’s pulp and paper producers to engage in high-risk practices. industries since the late 1980s. Pulp producers have

79 benefited heavily from the government’s policy of years. In addition, the plantation company is permitted making available large volumes of mixed tropical to draw on loans from the DR fund at commercial rates hardwoods, coupled with relatively minimal royalty to finance 32.5 percent of the project’s expenses. This payments (currently less than US$2.50 per m3). arrangement effectively allows the firm establishing the Through clearing of natural forest at affiliated HTI plantation to commit only 21 percent of the overall concession sites, Indonesian pulp producers have investment from its own funds. A recent audit of the DR obtained the bulk of their fiber at prices that are only fund carried out by the international accounting firm slightly above the cost of harvesting the wood and Ernst & Young determined that through the end of the transporting it to the mill. They have also been able to 1997-1998 fiscal year, the government had allocated purchase large volumes of pulpwood from IPK license- over Rp 1 trillion in DR monies to subsidize the holders and illegal harvesters at prices that are well development of 10 pulpwood plantation projects (Ernst below the wood’s actual stumpage value. While the cost & Young 1999). Conservatively converted at the mid- of producing a tonne of pulp fluctuates widely 1997 exchange rate of Rp 2400 per US$, this amounts to according to market cycles and monetary conditions, disbursements of roughly US$417 million, exclusive of access to such cheap fiber has often allowed Indonesian foregone interest earnings. mills to enjoy pulp production costs that range as low The Ernst & Young audit found that, in fact, many as 20 to 30 percent of those faced by North American recipients of the plantation subsidy have been able to and European producers.33 manipulate the process through which the DR monies Since the early 1990s, the Ministry of Forestry has are allocated so as to further reduce the portion of such also provided firms establishing pulpwood plantations projects that is funded by their own capital (Ernst & with heavily discounted finance and equity capital Young 1999). Most commonly, plantation companies through allocations from the government’s have overstated the net area to be planted at their HTI Reforestation Fund (Groome Poyry 1993). As outlined sites when they apply for the DR funds. In the case of a in chapter 2, the Forestry Department subsidizes HTI plantation company that realizes only 90 percent of the projects by providing 14 percent of the project’s total planted area stated in its application for DR support, cost in the form of equity capital and 32.5 percent in the without adjusting the distribution of funds, the portion form of a no-interest loan with a repayment period of 10 of the project’s total cost covered by DR monies rises from 46.5 percent to 51.7 percent. The Ernst & Young 33 One analyst (Hill 1998) summarized the significance of subsidized wood costs audit concludes that overestimation of HTI planted for Asia Pulp & Paper and other Indonesian producers as follows: “APP’s access to low-cost timber is key to its competitive advantage. According to a regional analyst, areas and similar irregularities resulted in the loss of APP’s imputed cost of wood to produce one tonne of pulp is Rp 280,000 (US$35). US$223 million from the DR fund between 1993 and These costs include government royalties, taxes, labor, and transport. By 1998. comparison, a confidential industry survey says, the imputed wood costs for a North American producer to produce one tonne of pulp are US$130 and for European producers about US$170. As of mid-November [1998], say the analysts, the taxes and royalties that APP and other Indonesian producers paid to the government for the wood needed for one tonne of pulp was just US$10. ‘Compared to producers elsewhere, they get the wood for free,’ says one analyst. Judging the changes in APP’s US dollar costs of labor and transport is more difficult, since some gains from depreciation have been offset by Indonesia’s high inflation rate.”

80 Table 4.3: Summary of Reforestation Fund Allocations to Pulpwood Plantation Companies, as of March 1998.

Company Affiliated Gov’t Grant 0-Interest Loan Commercial Loan Total Pulp Mill (Rp ‘000 bn) (Rp ‘000 bn) (Rp ‘000 bn) (Rp ‘000 bn) ______

Musi______Hutani Persada PT TEL 51.9 127.4 164.6 343.9

______Surya Hutani Jaya 36.6 90.5 61.7 188.8

______Menara Hutan Buana 43.5 100.9 0.0 144.4

______ITCI Hutani 28.0 88.9 0.0 116.9

______Tanjung Redeb Hutani Kiani Kertas 25.0 58.1 0.0 83.2

______Acehnusa Indrapuri 13.0 30.2 0.0 43.2

______Adindo Hutani Lestari 12.4 28.8 0.0 41.2

______Fendi Hutani Lestari 20.1 11.9 0.0 31.9

______Tusam Hutani Lestari 7.5 17.4 0.0 24.9

______Finantara Intiga 11.6 11.6 0.0 23.1

______Total 249.6 565.7 226.3 1,041.6

Source: Ernst & Young 1999

Soft Loans from State Banks and specific terms of repayment were generally negotiated Off-Budget Financial Allocations on a borrower-by-borrower basis, with companies tied In addition to providing pulp producers with under- to state elites often receiving terms far more favorable priced raw materials, the Indonesian government has than those available from commercial lending subsidized the development of some pulp and paper institutions (Winters 1992). It was not uncommon for mills through the allocation of discounted finance. credits from state banks to be “repeatedly renewed Under Suharto’s New Order regime, Indonesia’s with interest obligations capitalized into the loan rather seven state-owned banks regularly provided loans to than paid to the banks” (Cole and Slade 1996). Loans of investors with ties to elite government officials, this sort essentially functioned as “capital subscriptions regardless of whether the projects being funded were from which the banks received no cash returns.” likely to be profitable (Delhaise 1998). Such loans were Investors with particularly close ties to senior frequently based on political directive rather than officials were also able to obtain capital subsidies prudential calculations of risk, and often involved the through allocations from a variety of off-budget funds provision of little or no collateral on the part of the maintained by the New Order government (Ascher borrowing firms. Moreover, interest rates and the 1998). The state’s leadership kept these funds separate

81 from the government’s official budget to allow them to including customs duties that would normally be exert a high degree of discretion in channeling them charged on imported and exported goods.34 In addit- to favored projects or clients. One of the largest ion, Kiani has had access to low-cost wood from over sources of off-budget finance was the DR reforestation 2.7 million ha of timber concessions and plantation fund, which had total receipts of just under US$2.5 licenses then controlled by Hasan’s Kalimanis group billion between fiscal years 1993-1994 and 1997-1998 (Brown 1999). (Ernst & Young 1999). During the five-year period covered by the Ernst & Young audit, the DR fund Conglomerate-Owned Banks incurred losses of US$670 million as a result of and Related-Party Lending disbursements made by presidential decree for Since 1988 when the Indonesian government projects that were not related to reforestation (Ernst & liberalized the country’s commercial banking sector, Young 1999). most of Indonesia’s largest conglomerates have owned Under the New Order regime, none of Indonesia’s their own banks. As Table 4.4 shows, each of the major major pulp and paper investors was better placed to pulp and paper producers was also involved in the access these discretionary funds than Kiani Kertas. banking industry before the onset of the 1997 financial Owned by Hasan, the company secured much of the crisis. financing for its 525,000 tonne greenfield pulp mill in Under Indonesia’s commercial banking law, these East Kalimantan from the Indonesian government. and other private sector banks have been required to When the mill was constructed in 1997, the company follow a fairly extensive set of regulations designed to received at least US$300 million in loans from four ensure prudential management of commercial lending state banks, as well as a US$100 million allocation from institutions. In particular, these laws have placed the DR reforestation fund (Kompas 1999a; Borsuk numerous controls on lending practices in order to 1997). The government further subsidized the mill by maintain arm’s length transactions between banks and providing Kiani a 10-year holiday on corporate tax, the firms to which they loan money. Through the

Table 4.4: Indonesian Banks Controlled by Pulp and Paper Conglomerates Prior to the 1997 Financial Crisis ______Conglomerate Major Pulp/Paper Asset Bank Sinar______Mas Asia Pulp & Paper Bank Internasional Indonesia ______Raja Garuda Mas APRIL Unibank ______Barito Pacific Tanjung Enim Lestari Bank Andromeda ______Bob Hasan Kiani Kertas Bank Umum Nasional ______Bob Hasan/Apkindo Bank Bukopin ______Bob Hasan Bank Muamat ______Astra Surya Hutani Jaya Bank Universal

82 decade preceding the current crisis, however, the loaning out far greater sums of capital than Indonesian government’s financial regulatory agencies enforced law allowed. In practice, this meant that those banks’ these rules only sporadically. Moreover, on more than assets, including outstanding loans, were often one occasion, the New Order government took steps to considerably smaller than their outstanding liabilities. bail out failing private sector banks belonging to Violations of the government’s capital adequacy groups with strong political connections when their regulations were particularly problematic in that financial mismanagement threatened them with conglomerate-owned banks frequently loaned far insolvency. greater sums of capital to affiliated companies than In this weak regulatory environment, Indonesian Indonesia’s banking law allowed. Formally, the conglomerates frequently used banks under their government prohibited banks from extending more control—often illegally—to access much higher levels than 20 percent of their credit to firms with which the of finance than they would be able to secure from out- bank was affiliated through ties of ownership or side lending institutions (Deyang 1997). As one bank- management (Deyang, et al. 1997). Related-party ing industry executive explained, “It was not unusual lending above this limit is generally believed to expose for a group to buy a bank that no one had ever heard a bank’s depositors to an excessive degree of risk. On \of for US$5 million or so, and to use this bank as the the one hand, banks loaning money to affiliated vehicle for financing its major projects. In many cases, companies presumably have an incentive to provide this proved to be cheaper than borrowing capital at these funds at rates that do not adequately reflect the market rates from banks with which the group was not financial risks involved. On the other hand, banks are affiliated.”35 Two fundamental banking laws that the often loath to collect outstanding loans to affiliated government regularly failed to enforce were those companies if the borrower is unable or unwilling to stipulating the capital adequacy ratio (CAR) that private repay. sector banks were required to maintain and those Bob Hasan’s Kiani Kertas pulp project is believed to governing limits on lending to affiliated companies. have benefited substantially from the weak regulatory Since 1992, privately owned banks have been environment in Indonesia’s commercial banking sector. required to keep on hand capital stocks equivalent to Through 1997, Bank Umum Nasional, in which Hasan at least 8 percent of the bank’s total assets (Cole and was the majority shareholder, reportedly channeled 79 Slade 1996). This regulation was intended to ensure percent of its loans to sister companies (Indonesian that the banks would be able to maintain at least a Commercial Newsletter 1998). It is speculated that minimum amount of liquidity in the event that they much of this was channeled to Kiani while the mill was failed to recoup outstanding loans on schedule or that a under construction, including a portion of Rp 6.8 substantial portion of the bank’s depositors chose to withdraw their funds suddenly or unexpectedly. In the 34 One of Kiani’s special privileges has included the placement of a government years preceding the financial crisis, several of the customs office at the mill site. With its customs holiday, Kiani has been able to import capital goods directly to its mill and to export pulp without paying import- banks owned by conglomerates with major investments export duties, which are often on the order of 30 percent of the value of the goods in pulp and paper regularly violated the government’s themselves. It bears noting that as of November 2000, the Indonesian government continues to allow Kiani to enjoy this duty holiday. capital adequacy ratio regulations, in some cases

83 trillion in liquidity credits that the bank received investments in Indonesia’s pulp industry have varied from Indonesia’s central bank in the early weeks of quite considerably. The Sinar Mas/APP group, which the crisis to keep the bank solvent (Jakarta Post is often said to have among the lowest investment 1998). Through 1997, Bank Umum Nasional reported costs in the world, has reported spending operational income of only Rp 1.5 trillion while posting approximately US$1,100 per tonne of capacity in losses of Rp 4.4 trillion—much of this apparently being developing its Indah Kiat and Lontar Papyrus pulp incurred through loan defaults on the part of Hasan- mills (APP 2000).37 By comparison, the Raja Garuda affiliated companies (Indonesian Commercial Mas/APRIL group spent US$1,500 per tonne at its Newsletter 1998). At that point, the bank’s assets Riau Andalan Pulp & Paper facility. At the upper end of amounted to only 62 percent of its outstanding the spectrum, the Bob Hasan group reportedly built its liabilities. Kiani Kertas pulp mill at a cost of US$2,600 per tonne (Spencer and Choi 1999). Similarly, a partnership Financial Mark-Up Schemes between Indonesia’s Barito Pacific group and the In establishing new mills and adding production lines, Japanese trading company Marubeni claims to have Indonesian pulp and paper companies have frequently spent US$2,700 per tonne in developing the Tanjung secured lines of credit that well exceed the real costs Enim Lestari pulp plant (Bell, 1997). of their investments.36 They have done so by employ- There has been strong speculation among financial ing a variety of financial mark-up schemes, in which analysts and industry sources that the relatively high they report to investors and lending institutions a set costs of the Kiani Kertas and Tanjung Enim Lestari of inflated investment costs for projects for which they mills—each of which was roughly 75 percent above are seeking financing. By obtaining funds from banks the industry’s intermediate costs of US$1,500 per and investors at the marked-up level, the owners of an tonne of capacity -reflect substantial mark-ups during expanding pulp or paper company are able to reduce the investment process (Pulp & Paper Online 1998).38 the amount of capital that they, themselves, must If these reports are true, it suggests that these mills commit to the project, typically on the order of 30 involved mark-ups that may have been as high as US$ percent of the total cost of the investment. In cases 577 million and US$540 million, respectively. The where the mark-up is particularly high, companies are owners of these mills would then have been able to sometimes able to avoid committing any of their own use these funds however they wished, with few strings funds and, instead, to emerge from the investment attached. process with financing to spare. Such excess funds are 37 Although Sinar Mas/APP has a reputation for having among the lowest pulp frequently injected into the new mills in the form of and paper investment costs in the region, some analysts have questioned whether the group may also be inflating the costs of its expansion projects. For instance, working capital to generate what is known in the Singapore’s GK Goh brokerage house noted that “Indah Kiat’s recent capacity industry as “profit before operating.” expansions have been costly. Based on investment costs reported in APP’s bond As Figure 4.5 shows, the per unit costs of prospectuses, we have seen 25 to 30 percent investment cost increases for identical projects between October 1996 and April 1997, resulting in a long-term depressing effect on investment returns” (GK Goh 2000). 35 Confidential interview, Jakarta February 20, 1999. 38 Confidential interviews with pulp industry executive, Jakarta, February 18, 36 Confidential interviews with pulp industry executive, Jakarta, February 18, 1999; with finance executive, Jakarta, February 20, 1999; and with finance 1999, and with finance industry executive, Jakarta, February 20, 1999. executive, Singapore, April 8, 1999.

84 Figure 4.5: Reported Investment Costs Per Unit of Processing Capacity for Indonesia’s Major Pulp Producers

3,000

2,700 2,500 2,600

2,000 Cost (US $per tonne)

1,500

1,500 1,000 1,100

500

APP APRIL Kiani Kertas PT TEL

0 Sources: Spencer and Choi 1999; Bell 1997 Company

The use of financial mark-up schemes to generate encouraging Indonesian producers to develop large- capital above a project’s real cost is hardly unique to capacity mills in spite of the financial risks involved. Indonesia’s pulp and paper industries. On the By maximizing the price tag on a new mill (or a new contrary, such practices were reportedly a common production line), the company could ensure that its feature of high-cost investments throughout the investment would turn a profit even if the project ran Indonesian economy during the New Order period. into financial difficulties or collapsed later on. According to one pulp industry executive, Mark-up schemes in Indonesia’s pulp and paper industries have been structured in a variety of ways to All of Indonesia’s major conglomerates used mark-up circumvent both international and domestic financial strategies in one form or another. In fact, some of regulations. They have commonly involved the them lived off mark-ups—they would use the mark-up artificial inflation of costs for equipment and other from one project to finance the next. In some cases, the capital goods when new mills and production lines mark-up they got up front was the whole point of the are being installed. In some cases, the purchasing project, not the profits those projects would produce company makes an explicit arrangement with the down the road.39 vendors of the equipment to work with two different This emphasis on generating profits through the sets of invoices.40 One of these is based on the real diversion of funds during the investment process prices of the materials purchased, and the other is would appear to have played a significant role in based on inflated prices. While the purchasing

39 Confidential interview with pulp industry executive, Jakarta, April 16, 1999 and 40 Confidential interview with pulp industry executive, Jakarta, February 18, 1999. April 27, 1999.

85 company and the vendor use the first of these invoices Favorable Tax Laws for their actual transactions, the purchaser uses the and Accounting Procedures latter invoice to support its marked-up credit Indonesia’s favorable tax laws have provided yet applications with banks and investors.41 another means for the country’s pulp and paper In some cases, too, Indonesian pulp or paper firms companies to discount their capital costs. In particular, use affiliated offshore holding companies to serve as producers have benefited from government regula- intermediaries between themselves and foreign tions that allow firms to accelerate depreciation on vendors.42 The offshore holding company—which fixed capital assets for tax purposes. Generally essentially serves as a fictitious retailer -- will purchase accepted accounting procedures (GAAP) in both the capital goods from the vendor at their real price, Indonesia and the United States allow companies to and will then “resell” these goods to the pulp or paper record commercial depreciation charges over the life producer, issuing an invoice that records an artificially of a fixed asset, such as a piece of machinery or a mill. high price. The goods themselves, however, are In practice, this means that some portion of an asset’s generally shipped from the vendor straight to the total value can be charged as an expense and deducted producer, and never pass through the hands of the from the company’s gross profits each year that the holding company. asset is in use. In the case of a US$250 million paper Financial mark-up schemes are also reportedly machine that is expected to operate for 25 years, common in the construction phase for new mills and commercial depreciation on a straight-line basis would related infrastructure.43 In some cases, such projects result in charges of US$10 million per year for two-and- involve networks of fictitious contractors and a-half decades after the machine is installed. At a subcontractors, which are purported to be suppliers of corporate tax rate of 30 percent, commercial deprecia- necessary services. The mill owner typically works tion on this level would allow the company to avoid with a legitimate engineering firm to mark up the cost paying US$3 million per year in taxes for 25 years, at of the construction process—at times by as much as which point the machine would be fully depreciated. 50 percent—and much of the excess finance obtained Whereas commercial depreciation is a standard is then channeled through these fictitious companies. accounting procedure practiced in most countries of the world, Indonesian tax law permits companies to enjoy the added benefit of fiscal depreciation. The government’s fiscal depreciation regulations allow firms to depreciate for tax purposes the cost of an asset over the first half of the asset’s life. This allows companies to further reduce their tax liabilities during the years immediately following large capital invest- 41 One variation of this arrangement that has reportedly been common not only in the pulp and paper industries, but also in other parts of Indonesia’s forestry sector, ments. As a recent financial report on Indonesia’s pulp has been for the purchasing firm to report that it is buying new equipment when, in and paper industry explains, the tax benefit deriving fact, it is purchasing used equipment at a discounted price. 42 Confidential interview with pulp industry executive, Jakarta, April 27, 1999. from fiscal depreciation is a timing benefit only: 43 Confidential interview with pulp industry executive, Jakarta, December 8, 1999.

86 Table 4.5: Indah Kiat’s Accelerated Depreciation: FY1989—FY1996, excluding FY1995 (US$m)

Year Cumulative Commercial Fiscal Taxable Future Tax Machinery Depreciation Depreciation Income Liability Expenditure ______1989 250.6 3.4 (54.3) (16.2) 50.9 ______1990 465.4 13.9 (86.8) (39.7) 72.9 ______1991 466.7 19.9 (58.8) (22.4) 38.9 ______1992 671.1 22.5 (94.1) (36.9) 71.7 ______1993 687.1 40.0 (61.5) (24.2) 27.5 ______1994 710.0 35.7 (54.9) (15.8) 19.2 ______1995 1,473.2 71.1 n.a. n.a. n.a. ______1996 1,768.7 75.2 (151.9) (47.9) 76.7

Source: Derived from Spek 2000a.

Once the relevant piece of equipment has been fully regulations is that they encourage pulp and paper depreciated for fiscal purposes, commercial companies to engage in a process of perpetual depreciation is no longer an allowable deductible. expansion. As long as a producer is purchasing new Without such deductibles, taxable income will first turn equipment or installing new processing capacity, it is positive and, as tax credits run out, the pretax income able to enjoy the considerable tax benefits associated for fiscal purposes will be higher than that calculated with accelerated depreciation.44 This, in turn, can have on a commercial basis, resulting in tax payments that, a very positive effect on a company’s real cash flow. compared to the pretax commercial income exceed the Some financial analysts have argued that the tax top rate (Spek 2000a). benefits associated with Indonesia’s fiscal depreciation rules have played a central role in driving the aggres- In the case of the US$250 million paper machine sive expansion strategies carried out by the APP and mentioned above, for instance, fiscal depreciation APRIL groups during the 1990s (Spek 2000a; Ausnewz would allow the company to deduct US$20 million per annum from pretax earnings for the first twelve and a 44 Indonesian GAAP provides pulp and paper producers with an additional half years after the machine was installed. Thereafter, incentive to expand their operations in that firms are allowed to capitalize interest the company would be entitled to no further deduc- on work in progress. Although producers generally pay interest charges on their debt while their operations are expanding, they are not required to record such tions on the machine, and the firm’s annual tax burden payments on their balance sheets. This, in turn, enables them to publish higher would be higher than if it had recorded depreciation profits than would be allowed if they were required to follow more conservative US GAAP reporting requirements. Inflation of profits in this manner often functions to charges on a commercial basis. boost a company’s share price, as well as making its bond offerings more attractive An important effect of Indonesia’s fiscal depreciation to investors.

87 1999). By making large capital purchases on a regular burden has simply been deferred. During the period basis, these groups have been able to avoid a 1989-1996 when Indah Kiat avoided paying US$90 substantial portion of the tax obligations that would million through accelerated depreciation of its fixed otherwise consume up to 30 percent of their corporate assets, the company also incurred some US$358 earnings. million in future tax liabilities. Now that the firm has The case of Indah Kiat illustrates the cost benefits reached a point where it can no longer expand its that pulp and paper producers have derived from processing facilities in any significant way, analysts Indonesia’s favorable tax laws. Between 1989 and 1996, expect that Indah Kiat’s tax credits will rapidly run out the company expanded at a rapid pace, raising its pulp and the company will soon pay taxes at or above the production capacity from 120,000 to 925,000 tonnes per statutory rate of 30 percent. A substantial tax bill is year and installing capacity to produce 624,000 tonnes likely to cut sharply into Indah Kiat’s profits, and in per year of paper and board (Spek 2000a). Indah Kiat’s doing so, to reduce earnings margins at Asia Pulp & expenditures on machinery during these years grew Paper, which currently derives 50 percent of its profits from Rp 450 billion to Rp 4.2 trillion. Through this from Indah Kiat. period (excluding 1995), the company incurred depreciation charges of Rp 448 billion while recording ACCESS TO INTERNATIONAL FINANCE aggregate fiscal depreciation of Rp 1.19 trillion (Spek It would be misleading to suggest that Indonesian pulp 2000a). In real terms, this means that Indah Kiat took and paper producers have made large-scale advantage of Indonesia’s accelerated depreciation investments in high-risk projects solely, or even regulations to avoid paying some US$90 million in primarily, because domestic government subsidies and taxes over a period of seven years. It is likely that the weak financial regulations have enabled them to total sum of Indah Kiat’s foregone tax payments would discount their capital costs. International financial be considerably higher than this if the company’s fiscal institutions have also played a critical role in facilitating depreciation for the period from 1997 onward were the rapid expansion that has occurred in these also calculated. industries. Since the early 1990s, international To put Indah Kiat’s fiscal depreciation strategy in investment banks have channeled over US$12 billion perspective, it is helpful to recognize that since 1989 into Indonesian-based pulp and paper projects through the company has generated over seven million tonnes direct capital loans or by orchestrating bond offerings of paper and board products and just under eight that tap into North American and European debt million tonnes of pulp -- accounting for roughly 287,000 markets. Some of the industry’s largest producers ha of natural forest loss. By 1999, the company’s have also obtained funds by offering equity shares on annual sales exceeded US$1.3 billion and operating international stock exchanges, establishing joint profits were US$429 million. Yet, through the 1990s, ventures with offshore partners, and entering into Indah Kiat paid no corporate income tax to the vendor financing arrangements. Indonesian government. Among Indonesia’s pulp and paper producers, the In fact, the company has not been able to avoid Sinar Mas Group has been, by far, the most successful Indonesian taxes altogether—rather, much of its tax at securing international finance to carry out massive

88 expansions in processing capacity. In 1994, the group competitor, Raja Garuda Mas consolidated its pulp and placed its pulp and paper assets under the control of paper assets under APRIL, a Singapore-based holding the Singapore-incorporated holding company, Asia company, in 1994. The following year, the group listed Pulp & Paper. It did so to present itself to investors as APRIL on the New York Stock Exchange to generate a bonafide multinational, and to circumvent much of US$280 million in equity capital (Asiamoney 1996). the sovereign risk premiums associated with With its New York listing, APRIL also borrowed investments in Indonesia (Hill 1998). In 1995, the heavily to finance capacity expansions at its Riau group listed APP on the New York Stock Exchange, Andalan Pulp & Paper facility. Through 1998, APRIL’s and obtained US$311 million through its initial equity total debt had reached US$2.0 billion, versus total offering (Asiamoney 1996). Far more importantly, the assets worth US$3.3 billion (Ausnewz 1999). group’s New York listing enabled it to enter the US The relative ease with which APP and APRIL have bond market, which allowed it to secure much larger been able to obtain offshore financing underscores the amounts of capital than were possible through bank fact that the international investment community has borrowing. regularly underestimated or ignored the substantial Impressed by APP’s access to low-cost fiber, US risks associated with large-scale pulp and paper investors and international investment banks projects in Indonesia. This underestimation of financial enthusiastically supported an aggressive series of risk can be attributed to two components of the capacity expansions at the company’s subsidiaries process through which investment capital is channeled through the mid-1990s (Hill 1998). APP took advantage to high-growth industries in much of the developing of these circumstances to borrow nearly US$7 billion world. First, it reflects a general weakness in the due in the space of five years. APP’s total debt grew from diligence practices used by banks and other financial US$2.4 billion in 1994 to US$9.1 billion in 1998, while institutions to evaluate the risks associated with loans the group’s assets rose from US$4.1 billion to US$15.7 or bond offerings, particularly when these institutions billion (Ausnewz 1999).45 One analyst described this stand to make large short-term profits from such exponential growth by noting that “in only six years transactions. Second, loan guarantees provided by (1992-1998), the Sinar Mas Group built APP from industrial-country export credit agencies have insignificance to a point that it vied for a spot among substantially reduced the risk exposure of investment the world’s top 10 pulp and paper producers” (Hill banks, often motivating them to loan large sums to 1998). much riskier ventures than they might otherwise. The The Raja Garuda Mas Group, Indonesia’s second combined effect of these practices has been to place largest pulp producer, carried out a financial strategy undue structural pressures on Indonesia’s forests by that in some ways was remarkably similar to that of directing capital into pulp and paper capacity Sinar Mas, though on a much smaller scale. Like its expansions at costs that do not fully reflect the financial risks involved. 45 The bulk of APP’s long-term debt came in the form of bonds and notes payable, which grew from US$1.5 billion in 1995 to US$5.6 billion in 1998. By comparison, the group’s long-term bank debt rose from US$1.4 to US$2.5 billion during the same period (Ausnewz 1999).

89 Weak Due Diligence Practices Jaakko Poyry audit. The companies treat this as highly In raising funds through bond issues, pulp and paper proprietary and don’t like to release it. And [the bank] companies work with international investment banks. is not in a position to do our own audits like The bank is responsible for evaluating the project that [international accounting firm] Arthur Andersen. So will be supported by the funds generated from the we have to get information wherever we can ... bond, and for providing investors with a prospectus and to verify it through cross-checking.47 that offers the bank’s assessment of the likelihood that The fundamental lack of rigor involved in the due the bond will be repaid with interest when it comes diligence process would seem to be particularly due. The information presented in a bank’s due negligent to the extent that Indonesian pulp and paper diligence report plays a critical role in shaping investor producers are engaged in illegal practices. As decisions regarding whether or not to subscribe to a discussed above, there are strong indications that the particular company’s bond offering. pulp industry relies heavily on illegally harvested Interviews with investment bankers involved in wood and that several of the sector’s large producers financing Indonesian pulp and paper projects suggest have employed a variety of illicit financial practices in that the due diligence process has rarely involved funding their mills and plantations. Investment rigorous analysis of the large mills’ raw material bankers interviewed for this study generally indicated supplies. According to one bank officer who has that pulp producers’ use of illegal wood was not of played an active role in organizing bond offerings for direct concern to their banks unless it threatened to Asia Pulp & Paper, “Back in 1994-95, we finance people affect those companies’ profit margins. As one bank didn’t really discuss wood supply because there was officer put it: plenty of it. It’s only now that we’ve started talking about it—because suddenly wood is a problem.”46 [A client’s use of illegally-obtained fiber] would be a Even as the Sumatra mills face looming fiber deficits, concern to the extent that there was a possibility that however, the major banks that underwrote APP and that wood wasn’t going to be there in the future. If the APRIL’s rapid expansion continue to base their due company was going to get its license revoked or face diligence reports largely on information provided by heavy fines, or if the government was going to stop the the companies themselves. A senior financial analyst at illegal cutting, then this would be an additional a Singapore-based investment bank described this burden on those companies’ operating costs. Clearly, process as follows: we’d be concerned if their operating costs were going to go up significantly.48 Generally, I look at the information the company provides and see if it sounds plausible. This normally

includes the documents and reports that the company 46 Confidential interview, Singapore, February 1, 2000. is required to disclose to the SEC [US Securities and 47 Confidential interview, Singapore, February 1, 2000. This same financial analyst said that he generally visits these companies’ pulpwood plantations once Exchange Commission]. When I see that the company a year “to assess whether their claims regarding fiber supply are justifiable.” He has had an audit by [forestry consulting firm] Jaakko noted, however, that he has no training in forest management and “would not know if [he] was seeing 50,000 ha or 100,000.”When asked if his bank had ever Poyry, then I’m more confident in the information considered they’re providing. But I’ve never actually seen a 48 Confidential interview, Singapore, February 1, 2000

90 International investment banks, in fact, have strong noncollateralized guarantees for loans made by incentives not to look too closely at the projects they commercial banks to finance projects in countries, like fund. With bond offerings in particular, these banks Indonesia, involving high degrees of sovereign risk make substantial profits on commissions, which are (Stephens 1999). In practice, this means that the generally based on the number of notes or shares that export credit agency agrees to repay the banks if the investors purchase and the total value of the capital importer is, for any reason, unable or unwilling to raised.49 The bank normally receives an added bonus repay the loan when it comes due. In some cases, when a large-scale bond issue is fully subscribed. export credit agencies themselves provide investment Moreover, the banks, themselves, often have at least capital through direct loans (Fried and Soentoro 1999). short-term risk exposure with most initial public offer- Export credit agency loan guarantees have often ings in that they commit to purchasing a predefined played a critical role in securing project financing for portion of an offering’ shares. If the bond is under- high-cost investments, such as pulp and paper mills subscribed, then the banks are generally forced to sell (Stephens 1999). On the one hand, they encourage the shares they are holding at a marked-down rate. commercial banks to support such projects with capital loans, by reducing or eliminating the banks’ risk Export Credit Guarantees and Project Finance exposure. On the other hand, the export credit agency Loan guarantees provided by export credit agencies guarantees reduce the financing costs associated with (ECAs) from northern countries have also played a capital-intensive projects, which is frequently essential significant role in encouraging the flow of international for attracting investors. In both respects, the loan investment capital to high-risk projects in Indonesia’s guarantees effectively promote investments in finan- pulp and paper sector (Fried and Soentoro 1999). cially risky projects. In short, the export credit agency Industrial country export credit agencies are parastatal agrees to bear the cost if the project fails. Many export financial institutions which have a mandate to facilitate credit agencies, however, routinely pass on the risks capital investment projects involving the export of associated with such investments to the government of goods by their own country’s vendors. North American the importing country. They do so by requiring the and European export credit agencies, for instance, government to sign a counter-guarantee before the have actively supported overseas pulp and paper proj- export credit agency will provide the initial loan ects in order to promote exports of paper machines guarantees that are often required for large investment and other capital goods by home-country manufac- projects to move forward. With such counter- turers. They typically play this role by providing guarantees in place, the risks associated with private

49 One Singapore-based financial analyst estimated the profits that investment investments are ultimately borne by public institutions. banks have made through facilitating bond issues for Indonesian pulp and paper A recent study of 33 large investment projects in projects, as follows: “Banks get a straight commission of approximately 1.25 Indonesia during the period 1994-1997 found that the percent for bond origination and underwriting fees. They get an additional 0.5 percent in selling fees, depending on the bond's syndicate structure. All banks country’s pulp and paper sector has been a prime together, therefore, would have made—at abare minimum —1.75 percent on all of beneficiary of export credit agency loan guarantees APP's bond debt, at least through originating, underwriting and placing the bonds. This is before advisory fees, swaps, and trading transactions are taken into (Fried and Soentoro 1999). Surpassed only by the account.” Confidential interview, Jakarta, August 24, 2000. Will explain this as well: country’s power sector, large-scale pulp and paper

91 projects received US$4.2 billion in loans during this controversial pulp mill in South Sumatra, for period that were covered by export credit guarantees. example, involved 6 tranches ...The provision of ECA Mills known to have benefited from export credit guarantees in one tranche of the loan—[totaling agency support include Tanjung Enim Lestari, Indah US$650 million]—leveraged total project finance of Kiat, and Riau Andalan Pulp & Paper. As Fried and over US$1.3 billion. Soentoro (1999) explain, export credit agency guarantees often covered only a portion of the loans IMPACT OF THE FINANCIAL CRISIS AND REFORMASI made for these projects, but they functioned in part to Prior to the onset of the financial crisis in July 1997, leverage much higher levels of investment funds: Indonesian companies had plans to double the processing capacity of the country’s pulp industry by The finance packages for the larger ECA-supported the year 2005 (Jaakko Poyry 1998). This capacity projects typically involve a number of tranches, expansion included the installation of new production including long-term commercial loans (some covered lines at Indah Kiat and Riau Andalan, as well as the by private or public guarantees or insurance), equity, construction of several new mills by companies not revolving credit, and often and “ECA tranche” which previously active in the sector. With the international may be a commercially syndicated loan covered by investment community then giving strong signals that ECA guarantees... A 1997 US$1.3 billion loan to it would continue to support the development of large- Tanjung Enim Lestari for the construction of a

Table 4.6: Corporate Debt Owed by Indonesian Pulp and Paper Producers to Offshore Creditors and to IBRA, January 1999

Group Offshore Pulp/Paper Debt IBRA IBRA Debt Total (US$m) Pulp/Paper Debt Other Sectors IBRA Debt (Rp bn) (Rp bn) (Rp bn) ______Sinar______Mas /APP 9,075 n.a. 423 423 ______Raja Garuda Mas/APRIL 2,010 484 433 917 ______Kiani Kertas/Bob Hasan 670 2,480 1,997 4,477 ______PT TEL/Barito Pacific 911 n.a. 6,395 6,395 ______Surya Agung 250 n.a. n.a. n.a ______Basuki Rachmat n.a 1,634 n.a. 1,634 ______Kertas Leces n.a 308 n.a. 308 ______Total 12,916 4,906 9,248 14,154

Sources: Offshore debt figures extracted from Ausnewz (1999); domestic debt figures from IBRA (June 1999). [January 2000 exchange rate = Rp 6,700/US$]

92 scale pulp facilities in Indonesia, several of the coun- Corporate Debt try’s largest conglomerates were eager to participate in The fact that Indonesian pulp and paper producers had the seemingly endless flow of profits that such projects borrowed heavily to fund their capacity expansions offered. through the 1990s meant that many of these companies These new mill projects came to a sudden halt were particularly vulnerable when the financial crisis following the collapse of Indonesia’s monetary system hit the region. This was especially the case for compa- in late 1997. With the rupiah losing 80 percent of its nies carrying substantial loads of dollar-denominated value between July of that year and January 1998, the debt, which included each of the industry’s major country’s private sector was thrown into a severe liq- producers. As Table 4.6 shows, the country’s five uidity crisis that made new capital investment virtually largest producer groups held pulp and paper-related impossible. Domestic lending dried up as large num- debts totaling just under US$13 billion to offshore bers of private and state-owned banks became insol- creditors through the end of 1998.50 The largest por- vent. As significantly, offshore financial institutions tion of this, by far, was held by the Sinar Mas group’s pulled back from Indonesia as the economic crisis and holding company, Asia Pulp & Paper. subsequent political transformation pushed the In addition to their large offshore obligations, country’s sovereign risk ratings sharply upward. Indonesia’s pulp and paper groups are responsible for For pulp and paper producers operating in the sector over Rp 14 trillion in nonperforming loans that had before the crisis hit, the country’s economic and politi- been transferred to the Indonesian Bank Restructuring cal turmoil has had three significant, and in some Agency (IBRA) through January 1999. Converted at respects contradictory, effects. First, the crisis has put the January 2000 exchange rate of Rp 6,700/US$, this added financial pressure on Indonesia’s heavily- sum amounts to US$2.1 billion. Just over one-third of indebted producers by curtailing their access to capital this total—US$728 million—is owed to IBRA by four markets and by pushing some companies into receiver- companies operating specifically in the pulp and paper ship. Second, the depreciation of the rupiah has sector. The largest of these is Bob Hasan’s Kiani substantially reduced domestic pulp production costs, Kertas mill, which owes IBRA US$370 million to rank thereby providing Indonesian producers with windfall ninth on the agency’s list of over 4,000 corporate profits in many export markets, as their products are debtors. Kertas Basuki Rachmat, an integrated pulp sold in US dollars. Third, the weakening of the and paper producer located in East Java, ranks Indonesian state since the fall of the Suharto regime eleventh on IBRA’s list, owing the bank restructuring has substantially raised the financial risks associated agency US$244 million. with the country’s large-scale mills and pulpwood It is significant that the Barito Pacific and Bob plantations. Hasan groups also account for over US$1.2 billion in nonperforming loans owed to IBRA that are associated with investments in industries other than pulp and paper (Barr, et al., forthcoming). In the case of Barito

50 This figure includes US$2.7 billion that APP borrowed to finance its paper and board mill projects in China.

93 Pacific, it is possible that failure to resolve these Box 4.1: Indorayon and the debts could lead the bank restructuring agency to Financial Costs of Social Conflict 51 place in receivership the group’s equity interests in the Tanjung Enim Lestari pulp mill and its affiliated PT Inti Indorayon Utama is a US$600 million pulp and Musi Hutan Persada plantation. rayon mill in North Sumatra owned by Indonesia’s Raja Garuda Mas group. For several years, Batak Windfall Profits communities living near the mill have voiced concerns If the financial crisis has put added pressure on over environmental problems associated with its Indonesia’s heavily leveraged pulp and paper operations, including forest degradation, the release of companies, it has also created conditions that have noxious fumes, and a drop in the water level of nearby Lake Toba. In July 1998, local residents blocked trucks allowed them to earn windfall profits on much of entering the mill to keep them from bringing in raw their output. This has occurred because 60 to 70 materials, forcing Indorayon to halt production for four percent of the costs involved in pulp production are months (Thoenes 1998). Then, in January 1999, rupiah-based, while the remainder are linked to the violent clashes between community members and US dollar. When the rupiah lost 80 percent of its security forces led President Habibie to close the mill, value in the first six months of the crisis, Indonesian pending an independent audit (Jakarta Post 1999c). companies’ pulp production costs tumbled from The Jakarta Stock Exchange, in turn, suspended trading US$290 to less than US$100 per tonne (Thoenes of Indorayon shares. 1998; Goldman Sachs 1998).

Indorayon has paid a considerable financial cost for These low cash costs have sharply increased the its conflicts with the communities. The company posted competitiveness of Indonesian pulp in international net losses of US$40 million in 1998 (Fung 1999b). markets, and at times have made it possible for In March 1999, it failed to pay US$15 million in Indonesian producers to deliver pulp to the European bond coupon obligations, as well as US$144 million and North American markets at prices that are still owed to bond holders who wished to cash in their below those of the importing regions’ own producers guaranteed notes. At that point, Standard & Poor’s (Thoenes 1998; Spencer and Choi 1999). Through down-graded its ratings on US$110 million unsecured 1998 and 1999, for instance, the pulp production Indorayon notes due in 2000 and US$150 million costs of most European and North American produc- guaranteed notes due in 2001 to D from double-C (Dow Jones News Service 1999). The company has ers rarely dropped as low as US$400 per tonne. For since entered into discussions with creditors to integrated pulp and paper producers such as APP, the restructure its overall debt of US$360 million (Fung drop in pulp costs has also allowed the group’s paper 1999a). Financial analysts generally agree that the producers to remain profitable when international success of Indorayon’s restructuring proposal will paper prices have been low (Goldman Sachs 1998). depend on the outcome of the mill’s still-pending environmental audit and the company’s ability to 51 Extracted from Barr, etal. “Corporate Debt and the Indonesian Forestry Sector,” negotiate an effective settlement with the surrounding forthcoming in C. Colfer and I. Resosudarmo, eds. Which Way Forward? Forest, communities. Policy, and People in Indonesia, Resources for the Futrue, Washington, DC (expected publication 2001)

94 Increased Financial Risk mill, a pulp producer must not only be able to plant a The changes in Indonesia’s political landscape since sufficiently large area on an annual basis, but also to President Suharto’s forced resignation in May 1998 harvest each area planted when the trees mature have significantly raised the degree of financial risk seven to eight years later. In many parts of Sumatra associated with the country’s large-scale pulp and and Kalimantan, efforts on the part of HTI companies, paper mills, as well as pulpwood plantations. In partic- first, to clear large tracts of forested land, and then, to ular, the considerable weakening of the state apparatus place these areas under long-term management vis-à-vis Indonesian society has left many of these regimes have triggered intense disputes with both projects vulnerable to conflicts with surrounding indigenous and settler communities (Potter and communities. Whereas the New Order government Badcock 2000). In several reported cases, local peoples regularly used the nation’s military and police forces to have allegedly pulled up trees planted by HTI compan- keep local communities from threatening the interests ies and, at times, burnt plantation estates. In an on- of private sector investment projects, the post-Suharto going dispute involving the Musi Hutan Persada state has shown itself increasingly unwilling and plantation in South Sumatra, villagers have reportedly unable to do so. In many provinces, violent land and blocked company trucks from carrying wood from the resource conflicts between rural communities and HTI site to the Tanjung Enim Lestari pulp mill. extractive industries have become endemic. The financial risks that such conflicts pose are CONCLUSION AND POLICY OPTIONS magnified for Indonesia’s major pulp and paper pro- This paper has argued that the rapid expansion that jects for two reasons. First, the high levels of capital has occurred in Indonesia’s pulp and paper industries investment in large mills means that they incur sub- over the past decade has far outpaced efforts to deve- stantial costs if their operations are, for any reason, lop sustainably managed pulpwood plantations. As disrupted. Such costs become particularly problematic such, the country’s largest pulp mills—APP’s Indah for heavily leveraged companies, which need to main- Kiat and APRIL’s Riau Andalan—are facing looming tain a substantial cash flow to stay current on their fiber supply deficits over at least the next five to seven interest payments. The financial vulnerability of large years. Given the high fixed costs involved in pulp and mills has become readily apparent in the case of Inti paper production, Indonesian producers’ failure to Indorayon, the Raja Garuda Mas group’s US$600 secure a legal and sustainable fiber supply implies that million pulp and rayon facility in North Sumatra. For these projects carry a significant degree of financial much of the period since November 1998, communi- risk. At the very least, these mills’ production costs ties located near the mill have halted Indorayon’s are likely to increase sharply in the coming years as operations to protest the company’s negative impact on supplies of mixed tropical hardwoods available in the surrounding environment (see Box 4.1) Riau and surrounding provinces are exhausted. A second factor that magnifies the financial risks of To a significant degree, owners of Indonesia’s major social conflict for pulp and paper producers is their pulp and paper mills have carried out high-cost need to secure long-term control over large plantation capacity expansions because they have been able to areas. To establish a sustainable fiber supply for its avoid the financial risks involved. Pulp conglomerates

95 until now have had access to large volumes of of the industry. Options that government policymakers pulpwood fiber from natural forests at prices that are and financial institutions might consider include: well below the wood’s actual stumpage value. They have also received both direct and indirect capital 1. A moratorium on new pulp and paper processing subsidies through soft loans from government banks capacity expansions in Indonesia until full and and the Reforestation Fund; favorable tax laws that public audits of the companies’ pulp wood supply allow for accelerated depreciation of fixed assets; and plans are carried out. weak enforcement of Indonesia’s financial regulations, which has enabled companies to mark-up the cost of 2. Elimination of the wood supply subsidy to their investments and to borrow money from Indonesia’s pulp industry, by raising royalties and affiliated banks. fees to reflect the full stumpage value of the wood. As significantly, Indonesia’s pulp and paper producers have enjoyed relatively easy access to 3. Enforcement of the Indonesian government’s international finance, borrowing approximately US$12 1998 moratorium on the allocation of new forest billion to support their expansion efforts during the conversion licenses, in accordance with the 1990s. Weak codes of due diligence and loan guaran- government’s existing commitments to the IMF tees from industrial-country export credit agencies and the Consultative Group on Indonesia. have led international investment banks to fund high- This moratorium could be extended to include cost capacity expansion projects without adequately restrictions on new harvesting permits for existing evaluating the financial risks involved. The use of forest concessions slated for conversion. public monies to relieve the debt burdens of Indonesia’s pulp conglomerates, as will be discussed 4. Introduction of a credible independent monitoring in chapter 5, suggests that their debt-driven expansion program of plantation development (including the strategies have been characterized by a high degree use of aerial or satellite images) and sanctions of moral hazard. Indeed, just as these producers built provided for companies that fail to meet agreed- their mills with money that did not belong to them, upon sustainability targets. there are now indications that at least a portion of their debts will be paid off by funds coming initially from 5. Enforcement of improved due diligence practices industrial country taxpayers and ultimately from the on the part of financial institutions funding pulp and people of Indonesia. paper projects, so as to ensure that the financial By any account, the high capital costs associated risks associated with these projects are fully with pulp and paper processing suggests that it will assessed and that financing is not being allocated to be difficult to alleviate the structural pressures that projects involved in illegal practices, including use Indonesia’s existing mills place on the country’s of illegally obtained raw materials. remaining natural forests. However, there are steps that can be taken to enforce the adoption of more sustainable forest management practices on the part

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98 Kompas. 1999a. “Grup Kalimanis tak Manis karena Ditimpa Utang.” Paper: Plantation Development Programme: Toward Mill December 9. Capacity 2M Adt.” Unpublished data. Kompas. 1999b. “Diumumkan, Kredit Macet Perusahaan Bob Hasan,” Rubin, David. 2000. “Asia Pulp & Paper Company Ltd.” Nomura Asian December 8. Equity Research, Jakarta, August 24. Linebaugh, Kate. 2000a. “Asia Pulp & Paper Faces Shortages of Wood Sender, Henny. 1999. “Fair Share?” Far Eastern Economic Review, Fiber, Research Shows.” Bloomberg Newswire, November 27. July 22. Linebaugh, Kate. 2000b. “APP’s Debt Woes Dull Sparkle on an Solomon, Jay. 1999. “Concerns About Indonesia’s Sinar Mas Grow Indonesian ‘Jewel’ (Update 5).” Bloomberg Newswire, Amid Crackdown at Banking Unit.” Asian Wall Street Journal, October 5. August 16. Manurung and Kusumaningtyas. 1999. “Pembangunan Hutan Solomon, Jay. 1999. “Paper Weight?: Sinar Mas Woes May Hurt Tanaman Industri di Indonesia.” Draft preliminary report Group’s Plan for Growth.” Asian Wall Street Journal, August 16. prepared for WWF-Indonesia. Spek, Masya. 2000a. “Indah Kiat: Company Update.” GK Goh Mapes, Timothy. 2000. “APP’s Debt-Exchange Plan Ometraco Research, Singapore, August 1. is Only Short-Term Solution.” Asian Wall Street Journal, Spek, Masya. 2000b. “Indonesia – Forestry Sector: Out to Test the September 29 – October 1. Limits of Growth.” GK Goh Ometraco Research, Singapore, Ministry of Forestry and Estate Crops (MOFEC). 1999. November 29. “Perkembangan Pembangunan HTI-Pulp Tahun 1997/1998.” Spencer, Charles and Andy Choi. 1999. “Positioning for Asia’s Statistik Kehutanan Indonesia 1997/1998, Jakarta. Recovery.” Morgan Stanley Dean Witter, Singapore. Montlake, Simon. 2000. “Indonesia APRIL Units US$1.38 Billion Debt Stephens, Malcolm. 1999. The Changing Role of Export Credit Deal Draws Creditors’ Ire.” Dow Jones Newswires, November 8. Agencies. Washington, DC: International Monetary Fund. Montlake, Simon. 1999. “Interview: Singapore’s APRIL Group Close to Thoenes, Sander. 1998. “Falling Rupiah Gives Pulp Producers Hollow Debt Deal.” Dow Jones News Service, September 17. Victory.” Financial Times. Nadiar, Achmad. 2000. “Peluangnya Masih Fifty-Fifty.” Tropis, April. Winters, Jeffrey. 1992. “The Political Economy of Banking Reform in Paperloop.com. 2001. “APRIL Starts Up 700,000 tonne/yr Bleached Indonesia.” Unpublished paper prepared for the annual Hardwood Pulp Line,” June 1. conference of the Association of Asian Studies, Washington, DC, Potter, Joanne. 1999. “APRIL Looks for an Asian Spring.” Pulp and April 2-5. Paper Online.com, June. Witcher, S. Karene and Grainne McCarthy. 1999. “S&P Affirms APP’s Potter, Lesley and Simon Badcock. 2000. “The Effect of Indonesia’s Ratings, Warns Investors.” Asian Wall Street Journal, August 19. Decentralization on Forests and Estate Crops: Case Study of World Bank. 2001. Indonesia: Environment and Natural Resource Riau Province, the Original Districts of Kampar and Indragiri Management in a Time of Transition. Washington, DC: Hulu.” Draft manuscript prepared for the Center for World Bank. International Forestry Research (CIFOR), Bogor, Indonesia, October 2000. Pruitt, Angela. 2000. “Indonesian Corporate Set to Re-Enter Bond Market Via China.” Dow Jones Newswires, February 28. PT Indah Kiat Pulp & Paper Tbk. 1999. “Form 20-F for Fiscal Year Ended December 31, 1999.” Securities and Exchange Commission, Washington, DC. PT Tanjung Redeb Hutani. 1996. “Jadwal Pembangunan HTI/Development Schedule – PT Tanjung Redeb Hutani, 1993- 2001.” October. Pulp & Paper. 1999. “APRIL Plans New Kraft Pulp Line.” October. Pulp & Paper International. 1999. “Kiani Kertas’ Management Will Remain in Place.” January. Pulp & Paper Online. 1998. “Indonesian Companies’ Troubles Mount; Indorayon, Kiani Kertas Face Uncertainty.” September 28. Pulp & Paper Week. 1997. “Southeast Asian Turmoil Prompts Some Expansion Delays.” December 8. Pranasidhi, Edhi. 1998. “Indonesia’s ‘Bob’ Hasan Offers Paper Company to Government for Funds Used.” Dow Jones Newswires, September 7. Riau Andalan Pulp & Paper (RAPP). 2001. “PT Riau Andalan Pulp &

99 Corporate Debt and Moral Hazard in Indonesia’s Forestry Sector Industries

Chapter 5 In their efforts to restructure Indonesia’s timber and wood key conditionality from the IMF and with technical processing industries, the IMF and the World Bank have assistance from the World Bank. Broadly defined, IBRA’s taken steps to remove a range of subsidies that the mandate has been to refloat Indonesia’s failing banking Indonesian government extended to the nation’s forest system and, by extension, to play a central role in sector conglomerates under Suharto’s New Order regime. resolving the nation’s corporate debt crisis. The most significant policy interventions put forth by the In this capacity, IBRA has assumed control over some multilateral development banks in this regard have Rp 645 trillion, or US$92 billion in assets, giving the included: agency far-reaching influence over Indonesia’s banking ______and corporate sectors (IBRA 2001).1 These assets include Chapter by: Increased log royalties to reduce the flow of timber an estimated US$3 billion in outstanding loans directly Christopher Barr and rents to HPH concession-holders; associated with forestry sector investments, as well as Bambang Setiono ______several billion dollars worth of pledged equity shares in Removal of log export restrictions to prohibit three of Indonesia’s largest forestry conglomerates. The Indonesian wood processors from obtaining raw agency has thus far succeeded in recovering only a very materials at costs substantially below world small fraction of the debts in its portfolio, and there are market prices; ______strong indications that much of this debt will eventually be Abolition of the monopoly on plywood exports marked down or written off. To the extent that Indonesia’s held by Apkindo; forestry sector conglomerates are able to avoid repaying ______the debts now owed to IBRA, the government will Audit and transparent management of the effectively be returning to these actors a substantial share government’s Reforestation Fund. ______of the subsidies that the IMF and the World Bank have sought to remove. Collectively, these reforms have been aimed at blocking Viewed from a broader perspective, the concentration the flow of forest sector rents to key clients of the Suharto of indebted forestry and estate crop companies under regime, while also introducing market-based efficiency IBRA would appear to offer a unique institutional into all aspects of the country’s timber and wood mechanism for addressing some of the core structural processing industries. To varying degrees, perhaps, each problems facing Indonesia’s forestry sector. By calling in of these policy interventions is rooted in the assumption debts held by insolvent wood processors, for instance, that capital subsidies invariably lead timber producers and IBRA could play a key role in reducing the overcapacity wood processors to undervalue forest resources, which in that currently exists in the country’s wood processing turn lead to unsustainable management practices. industries. To date, however, IBRA has restricted its focus Whatever success the World Bank and the IMF have to restructuring the debts held by companies in its had in eliminating forest sector subsidies may well be portfolio and selling assets to raise cash for the bank offset by the bank recapitalization and corporate debt recapitalization process. resolution processes currently being carried out by the 1 In this chapter, dollar-equivalents of rupiah-denominated figures are calculated Indonesian Bank Restructuring Agency (IBRA). The on an exchange rate of Rp 7,000 per US$, unless noted otherwise. Indonesia’s government created IBRA in early 1999 in fulfillment of a exchange rate has fluctuated widely since 1997, ranging from approximately Rp 2,400 per US$ in June of that year to Rp 17,000 at the height of the monetary crisis.

100 This has created a situation in which many heavily has closed 70 of the nation’s 238 banks since the onset of indebted forestry and estate crop enterprises have been the financial crisis (Jakarta Post 2001b). The agency has allowed to continue operating under their pre-crisis taken over 13 privately owned banks, although this owners, with minimal supervision from IBRA, as long as number has since been reduced through mergers to four.3 they agree to repay some portion of their debts over time. Through late 2001, IBRA has also recapitalized 27 banks. In some cases, debt restructuring has been linked explic- These include four state-owned banks4; 11 private banks5; itly to further expansion of these companies’ operations. and 12 smaller regional development banks (Jakarta Post The fact that many Indonesian forestry conglomerates are 2001c). engaged in high-risk and illegal activities suggests that Under the recapitalization process, the government IBRA is creating the conditions for future financial injected up to 80 percent of the funds needed to bring the instability and reinforcing the poor corporate governance banks’ capital adequacy ratios to 4 percent, while the that has long existed within the country’s forestry sector. banks’ owners were required to contribute the remaining 20 percent.6 In turn, all nonperforming loans were IBRA AND BANK RECAPITALIZATION stripped from the recapitalized banks’ portfolios and IBRA was founded with the issuance of Government transferred to IBRA. The government obtained equity Regulation 17 in February 1999 (Lindgren, et al. 1999). shares in the banks in direct proportion to the percentage Placed under the Ministry of Finance, the agency was of recapitalization funds that it injected. In most banks, the given far-reaching legal authority to implement the government’s share has been 80 percent; however, in at government’s ‘General Bank Recapitalization Program,’ as least one case, the government’s share until recently was defined by a Joint Decision from the Minister of Finance and the Governor of the Bank of Indonesia in December 1998.2 IBRA was assigned a broad mandate to restructure and revitalize the country’s collapsed banking sector, which has included the implementation of “a bank liability 3 In June 2000, nine banks taken over by IBRA were merged with Bank Danamon. guarantee program, bank restructuring, restructuring These included: Bank Tiara Asia, Bank PDFCI, Bank Duta, Bank Nusa Nasional (BNN), Bank Risjad Salim International, Bank Tamara, Bank Pos Nusantara, Bank of bank loans, shareholder liability settlements, and the Jaya International, and Bank Rama. Other banks taken over by IBRA include Bank recovery of state funds provided as liquidity assistance Central Asia, Bank Bali, and Bank Niaga. 4 State-owned banks that have been recapitalized include Bank Mandiri, Bank to banks” (IBRA 2001). Negara Indonesia, Bank Rakyat Indonesia, and Bank Tabungan Negara. It should be In this capacity, the agency has conducted portfolio noted that Bank Mandiri was formed in late 1999 through a merger of four large reviews of the nation’s private and state-owned lending state-owned banks that were in operation before the 1997 crisis. 5 Seven private banks were recapitalized outright, including the publicly listed Bank institutions to classify Indonesian banks into four cate- Lippo, Bank Internasional Indonesia and Bank Universal; and the non-listed Bank gories: those to be closed; those to be taken over and Prima Ekspress, Bank Artha Media, Bank Patriot, and Bank Bukopin. Four private- sector banks were first taken over by IBRA before they were recapitalized, including managed by the government; those to be recapitalized; Bank Central Asia, Bank Danamon, Bank Niaga, and Bank Bali. and those that are sufficiently healthy to continue 6 A bank’s capital adequacy ratio refers to its cash assets as a percentage of total operating on their own. Through IBRA, the government loans outstanding. Before the 1997 financial crisis, Indonesia’s commercial banking law required banks to maintain a capital adequacy ratio of 8 percent to 2 Surat Keputusan Bersama Menteri Keuangan Republik Indonesia dan Gubernur ensure that they would be able to stay solvent in the event that they were unable to Bank Indonesia No. 53/KMK.017/1999 dan 31/12/KEP/GBI Tentang Pelaksanaan collect on outstanding obligations on schedule or were suddenly subject to larger Program Rekapitalisasi Bank Umum. than expected withdrawals by depositors (Cole and Slade 1996).

101 Table 5.1: Government Bonds Issued for Banking instruction, the Indonesian government agreed to issue an Sector Restructuring, as of December 31, 2000. additional Rp 30 trillion in bonds to further bolster the government’s bank guarantee scheme. Many financial analysts speculate that the costs of the ______Category of Bonds Value (Rp trillions) recapitalization program may rise substantially if ______Bank Recapitalization 425.54 Indonesian banks are unable to generate sufficient levels ______BLBI Liquidity Credit 144.54 of real earnings through normal bank lending (World ______Bank Guarantee Program 73.78 Bank 2000; Murphy 2000). In recent months, the recap- ______Bank Credit Program 9.97 italized banks have struggled to operate profitably due to Total 653.82 ______Indonesia’s high interest rates and the weakness of the Source: IBRA 2001. rupiah. Consequently, most of these institutions continue to have highly unbalanced asset structures, with the bulk as low as 57 percent as the bank’s shareholders con- of their assets being in the form of government bonds tributed more than the minimal amount of funds (IBRA rather than outstanding loans. In March 2001, for instance, 2001). In the second phase of the recapitalization process, the Ministry of Finance reported that government participating banks are obliged to raise their capital ade- recapitalization bonds accounted for between 40 and 70 quacy ratio to 8 percent by the end of 2001, according to percent of the assets held by state banks and for over 50 the government’s agreement with the IMF (Jakarta Post percent of the assets held by three of the largest private 2001c). banks that have been recapitalized (Jakarta Post 2001c). In June 1999, Standard & Poor’s international ratings This situation is complicated by the fact that the govern- agency estimated that the up-front fiscal cost of resolving ment’s recapitalization bonds, thus far, have proven to be Indonesia’s banking crisis will amount to US$87 billion, or highly illiquid, as demand for these bonds in secondary 82 percent of the country’s 1998 GDP (Standard & Poor’s markets has been minimal. The government is, therefore, 1999).7 These costs have largely been incurred through faced with the possibility of having to inject substantial the issuance of government bonds related to various new sums of capital into the banking system to prevent the components of the bank restructuring process. Through closure of banks unable to reach the 8 percent capital December 31, 2000, the government issued some Rp 654 adequacy ratio by the end of 2001 (Kompas 2001c). trillion in bonds, worth approximately US$93 billion (see Table 5.1). Bonds issued to finance the bank recapitali- Recapitalization of Forestry-Linked Banks zation process amounted to Rp 425 trillion (US$61 billion), Prior to the 1997 financial crisis, conglomerates with or two-thirds of the total sum. In August 2001, at the IMF’s substantial investments in forestry and estate crop industries controlled 10 of Indonesia’s private-sector banks 7 Standard & Poor’s defines ‘up-front fiscal cost’ as the funds provided by the (see Table 5.2). Under IBRA’s bank restructuring process, government to initially recapitalize or pay out creditors of distressed banks. This is two of these banks have been closed; four have been taken distinguished from ‘final costs,’ which are defined as "costs net of recoveries on collections of bank loans, on the disposal of bank assets, and after privatization of over; and four have been recapitalized (including the Salim seized financial institutions." Although the final costs of rescuing Indonesia’s Group’s Bank Central Asia, which was first taken over by banking sector may ultimately be lower than the up-front fiscal cost, the latter better represents the real pressure on public finance and monetary policy. the government). Of the forestry-linked banks, only the

102 Table 5.2: Current Status of Banks Controlled by Conglomerates with Substantial Investments in the Forest and Estate Crop Sector before the 1997 Crisis ______Group Bank Status Under IBRA ______Astra Bank Universal Recapitalized ______Bakrie Bakrie Bank (Bank Nusa) Taken Over ______Barito Pacific Bank Andromeda Closed ______Bob Hasan Bank Umum Nasional Closed ______Bob Hasan Bank Duta Taken Over/Merged ______Bob Hasan/Apkindo Bank Bukopin Recapitalized ______Raja Garuda Mas UniBank Not under IBRA ______Sinar Mas Bank Internasional Indonesia Recapitalized/Merged ______Salim Bank Central Asia Taken Over/Recapitalized ______Salim Bank Risjad Salim Int’l Taken Over/Merged

Source: Barr, et al., forthcoming.

Raja Garuda Mas Group’s Unibank has remained Corporate Debts Held by IBRA independent of IBRA. Under the bank restructuring process, IBRA has assumed For the handful of conglomerates whose banks qualified control over outstanding bank loans to over 4,000 private for this process, recapitalization has brought substantial sector companies totaling Rp 349 trillion, or US$50 billion benefits. Not only have these groups’ banks been able to (IBRA 2001). These debts represent both performing and stay in business, but they have also been able to unload nonperforming loans stripped from the books of the banks large sums of bad debt from their balance sheets. As that have been closed, and all nonperforming loans from significantly, recapitalization has helped these groups to the banks that have been taken over and/or recapitalized. protect their non-bank assets, which often held out- Approximately two-thirds of the loans in IBRA’s portfolio, standing obligations that would be transferred to IBRA or valued at Rp 230 trillion (US$33 billion), have been classi- other creditors if the bank became insolvent. In at least fied as non-performing debt—defined to include all loans one case, the government injected over US$900 million in more than three months past due, as well as all restruc- recapitalization funds into a bank that still carried on its tured debt. To put this in perspective, the aggregate debt books US$1.3 billion in outstanding loans to affiliated in IBRA’s portfolio represents 32 percent of Indonesia’s forestry companies (see Box 5.1). 1998 GDP and 72 percent of that year’s total exports (Standard & Poor’s 1999). Data released by IBRA in early 2001 indicates that the agency currently holds Rp 21.9 trillion (US$3.1 billion) in

103 Box 5.1: Recapitalization of Bank Internasional to 30 months and securing pledged collateral from Sinar Mas valued at 145 percent of the amount owed. Collateral Before the 1997 financial crisis, Bank Internasional Indonesia (BII) assets included equity shares in New York-listed Asia Pulp & was controlled by the Sinar Mas Group, the nation’s largest pulp Paper and other operating subsidiaries. and paper producer. Through the 1990s, the bank regularly held several billion dollars in deposits from the group’s Singapore-based Mounting debts and falling paper prices resulted in a sharp holding company, Asia Pulp & Paper and other affiliates. BII was deterioration in Sinar Mas’s financial position during the managed by the family of Eka Tjipta Widjaja, the principal second half of 2000, with APP losing 96 percent of its share shareholders in Sinar Mas. After the crisis struck, it had a negative value on the year. This raised concerns that the collateral shareholder value of Rp 7 trillion (US$1 billion) and needed assets pledged to IBRA would no longer cover the related-party additional capital of Rp 11 trillion (US$1.6 billion) to stay solvent loans, in the event of a Sinar Mas default. In February 2001, (Sender 1999). In April 1999, BII was one of seven private sector the Indonesian government issued an irrevocable guarantee banks to qualify outright for the government’s recapitalization that these loans would be repaid (AFXAsia 2001). Ministry program. The government injected Rp 6.6 trillion (US$942 million) of Finance officials claimed that the government had few into the bank in the form of recapitalization bonds, thereby assum- alternatives, as a Sinar Mas default on the debts to BII ing a 58 percent equity stake. Sinar Mas and the Widjaja family would certainly lead to the collapse of the newly recapitalized contributed Rp 4.4 trillion to retain an 18 percent share of BII. bank. This would carry high costs, as the government would effectively lose its up-front ‘investment’ in the bank’s At the time of its recapitalization, Bank Internasional Indonesia had recapitalization and would need to pay out approximately Rp 30 US$1.2 billion in outstanding loans to subsidiaries of the Sinar trillion (US$4.3 billion) to cover depositor losses Mas Group (Adityaswara 2001). Representing 52 percent of the (Adityaswara 2001). bank’s total loans, this constituted a breach of the government’s 20 percent legal lending limit to affiliated parties (Webb 2001a). As a In issuing its guarantee of the related-party loans, the result, members of the Widjaja family failed a ‘fit and proper’ test government instructed IBRA to secure collateral assets administered by Indonesia’s central bank and were removed from from the Sinar Mas Group worth Rp 23 trillion. The government the bank’s management (Rubin 2000). To ensure that these loans has also taken over all remaining shares in BII, and has would be repaid, IBRA signed a memorandum of understanding now merged it with state-owned Bank Mandiri. with Sinar Mas and BII in March 2000 extending the tenor of the loans

debts that are directly related to forestry investments facilities; 8 percent by wood processors with affiliated (IBRA 2001; Brown 2001). These debts were generated by HPHs; and 4 percent by pulp and paper producers. 128 companies with activities in timber extraction and/or According to IBRA, the activities of 38 indebted forestry wood processing. As Table 5.3 shows, Rp 11.8 trillion companies, accounting for Rp 3 trillion (US$430 million), (US$1.7 billion)—or over half of the total forestry debt—is have not yet been determined. owed by wood processing companies without HPH timber Analysis of IBRA’s forestry debt by business group (or concessions. At least 20 percent of the outstanding debt is “obligor”) indicates that five conglomerates are respon- owed by HPH concession-holders without processing sible for roughly two-thirds of the total obligations (Brown

104 Table 5.3: Area of Activity for Forestry Companies with Debts Under IBRA

Forestry Activities No. of Firms Total Oustanding Debt (billion Rp) ______HPH concession 23 4,288 ______Wood processing w/out HPH 52 11,800 ______Wood processing w/ HPH 11 1,700 ______Pulp and paper 4 873 ______Not yet determined 38 3,000 ______Total 128 21,661

Source: Unpublished IBRA data

Table 5.4: Outstanding Forestry Debts under IBRA by Obligor, March 2001

Outstanding Forestry Debt Total Outstanding % of Total No. of Firms % of Total by Group “Obligor” (Top 12 Only) (billion Rp) ______Bob Hasan 7,024 32.1 16 12.5 ______Djajanti 3,321 15.2 6 4.7 ______Raja Garuda Mas 1,476 6.7 7 5.5 ______Barito 1,374 6.3 9 7.0 ______Batasan 1,155 5.3 4 3.1 ______Dirgahayu 915 4.2 2 1.6 ______Andatu 497 2.3 1 0.8 ______Sumatera TUD 473 2.2 5 3.9 ______Hutan Raya Indonesia 460 2.1 5 3.9 ______Surya Dumai 426 1.9 4 3.1 ______Kayu Mas 412 1.9 5 3.9 ______Kayu Lapis/Henrison 369 0.7 4 3.1 ______ALL OTHERS 3,973 18.0 60 47.0 ______TOTAL 21,882 100.0 128 100.0

Source: Brown 2001

105 2001). As shown in Table 5.4, these groups include the FORESTRY ASSETS PLEDGED TO IBRA Hasan, Djajanti, Raja Garuda Mas, Barito, and Andatu In addition to corporate loans transferred to IBRA from conglomerates, which collectively account for Rp 14.4 banks involved in the restructuring process, the agency trillion (US$2.1 billion) in outstanding forestry debt under holds pledged equity shares in companies owned by IBRA. Notably, over one-third of IBRA’s forestry debt is several of the nation’s largest conglomerates. These linked to three specific firms: the Bob Hasan Group’s include all of the corporate holdings of two of Indonesia’s Kiani Kertas (Rp 2.8 trillion) and Kiani Lestari (Rp 2.3 leading forestry producers, the Salim Group and the Bob trillion); and the Djajanti Group’s Nusantara Plywood (Rp Hasan Group. IBRA also holds Rp 23 trillion in assets 2.7 trillion) (Brown 2001). pledged by the Sinar Mas Group, Indonesia’s largest pulp It is important to note that the data on forestry debt and paper producer. released by IBRA do not include outstanding debts held IBRA secured asset pledges from the Salim and Hasan by Indonesian forestry conglomerates in industries out- conglomerates in an effort to guarantee repayment of Rp side the forestry sector. Such non-forest debts are known 38 trillion (US$4.9 billion) in Bank Indonesia liquidity to be quite large, as major producers in the forestry sector credits (bantuan likuiditas Bank Indonesia, or BLBI) also have holdings in automobile manufacturing, petro- extended to those groups’ banks in 1997 and 1998 chemicals, food production, shipping, property, and a (Kompas 2000b). These credits were allocated by Bank range of other industries. An analysis of debts held by Indonesia in the early months of the financial crisis as part Indonesian forestry conglomerates, based on IBRA data of a larger effort to prevent depositor runs on the from January 1999, found that the 10 largest groups then country’s private lending institutions. During this period, accounted for at least Rp 10.7 trillion (US$1.5 billion) in the central bank transferred some Rp 144.5 trillion (US$20 such extra-sectoral debts (Barr, et al. forthcoming). It is billion) to 48 banks, including several controlled by likely that this figure has grown substantially since those conglomerates with close ties to President Suharto data were collected, as significant amounts of additional (Sondhi 2000). An official audit of the BLBI by Indonesia’s debt have since been moved from Indonesian banks to State Auditing Agency in mid-2001 found that 95 percent IBRA. of the credits allocated were misused by the recipient The forestry debt figures released by IBRA also do not banks (Jakarta Post 2001a). In many cases, these funds reflect the large offshore debts held by Indonesian were channeled to companies affiliated with the owners of forestry conglomerates. At present, it is estimated that five the banks, and much of the money is believed to have of these groups are carrying nearly US$17 billion in been moved offshore in the early weeks of the crisis. outstanding obligations to foreign creditors. Conservative Two of the largest beneficiaries of the Bank Indonesia estimates of the dollar-denominated debts held by these liquidity credit scheme were the Salim Group’s Bank conglomerates are as follows: Sinar Mas (US$12 billion); Central Asia and the Hasan Group’s Bank Umum Raja Garuda Mas (US$1.6 billion); Astra (US$1.1 billion); Nasional, which received allocations of Rp 26 trillion Salim (US$1 billion); Barito (US$1 billion) (Barr, et al., (US$3.7 billion) and Rp 12 trillion (US$1.7 billion), forthcoming). respectively (Kompas 2000b).8 Under IBRA’s bank restructuring program, Bank Central Asia was taken over by the government in May 1998 and recapitalized, while

106 Table 5.5: Forestry Assets Pledged to IBRA by the Salim and Bob Hasan Conglomerates

______Type of Firm Salim Group Bob Hasan Group Co’s Total Area or Capacity Co’s Total Area or Capacity ______HPH timber concession (2) 280,000 ha 8 1,322,000 ha ______Sawnwood, moulding (2) 70,000 m3/yr (2) 73,000 m3/yr ______Plywood 3 290,000 m3/yr 4 335,000 m3/yr ______Pulp and paper 0 2 660,000 tonnes/yr ______HTI plantation 1 13,800 ha 3 249,000 ha ______Oil palm plantation 24 271,000 ha 0 ______Non-forestry/estate crop 79 13 ______Total 107 30 Note: Figures in Percentages refer to companies with operations in more than one category. Source: IBRA 2000a.

Bank Umum Nasional was closed in August 1998. To generated by profit flows from the pledged companies and ensure repayment of the BLBI funds, IBRA has required strategic asset sales. the banks’ owners to pledge controlling shares in other To cover the BLBI credits, the Salim Group has pledged businesses owned by their conglomerates (Sondhi 2000; controlling shares in some 107 companies to IBRA (see Kompas 2001b). Table 5.5). These include two HPH timber concessions Under the terms of a Master Settlement and Acquisition with a combined area of 280,000 ha; three plywood Agreement signed with each group, IBRA has placed the companies with an annual capacity of 290,000 m3 per year; pledged assets in separate holding companies overseen by and 24 oil palm plantation estates. The Bob Hasan Group the agency’s Asset Management Investment unit. In each has, likewise, pledged equity shares in 30 companies to case, the groups’ pre-crisis owners retain legal ownership IBRA, including eight HPH timber concessions covering over the pledged companies, as long as they abide by the 1.3 million ha; two HTI pulpwood plantations; four plywood terms of the agreement. Through these agreements, IBRA companies with a combined production capacity of 335,000 has arranged to receive repayment of the BLBI liquidity m3 per year; and PT Kiani Kertas, one of Indonesia’s credits over an extended period of time, with funds being largest pulp producers. In addition to the companies pledged by the Salim and 8 Aside from business groups directly owned by members of the Suharto family, no Indonesian conglomerates had closer ties to President Suharto before the 1997 Hasan groups to cover BLBI liquidity credits, IBRA has financial crisis than the Salim and Hasan Groups (Schwarz 1994). The Salim Group also secured pledged assets valued at Rp 23 trillion from is controlled by the family of Liem Sioe Liong, whose business partnership with the Sinar Mas Group (Adityaswara 2001). The agency Suharto originated in the 1950s. Bob Hasan, likewise, began working with Suharto when the future president was a colonel in Java’s Diponegoro Division (see Barr obtained these assets in May 2001 as collateral for the 1998). Both groups had numerous joint ventures with Suharto and his children Indonesian government’s guarantee of US$1.3 billion in during the New Order period, giving them unparalleled access to financial and regulatory support from the Indonesian government. related-party loans from Sinar Mas-owned Bank

107 Internasional Indonesia. (The circumstances leading the (US$92 billion) (Kompas 2001a).9 Outstanding bank loans government to issue this guarantee will be discussed later managed by the agency’s Asset Management Credit unit in this chapter). Assets pledged by Sinar Mas include land, were found to have a fair value of only 22 percent of their buildings, equipment, and other physical assets associated total book value. Likewise, equity shares and other with the group’s two pulp mills and six paper and board collateral assets pledged by the shareholders of banks that production facilities in Indonesia. IBRA also secured have been closed or taken over were found to have a fair options to assume control over the group’s two largest value that amounts to only 20 percent of their book value pulpwood plantation companies. (IBRA 2001). In the case of bank loans, this ‘overvaluation’ reflects CAPITAL SUBSIDY THROUGH DEBT WRITE-OFF the poor due diligence practices employed by Indonesian The large-scale transfer of debt and equity-holdings from lending institutions in the years prior to the 1997 financial Indonesia’s failing banks to IBRA has made the agency the crisis. A general failure on the part of both private and single largest holder of corporate assets in the nation’s state banks to adequately assess the risks involved in the forestry sector. In handling these and other assets in its ventures they financed led to large numbers of nonper- portfolio, IBRA has been guided by its mandate from the forming loans with little or no real collateral (Winters Ministry of Finance to raise funds to help offset the 1992; Cole and Slade 1996). In particular, the widespread considerable costs associated with recapitalizing the use of financial ‘mark-up’ schemes meant that many of the nation’s banking sector. For 2001, IBRA has been assigned loans later transferred to IBRA were for substantially a target of generating Rp 27 trillion (US$3.9 billion) for the greater amounts than what had actually been needed by state budget (Wright 2001). the projects they funded.10 The agency is raising these funds primarily in two ways: While IBRA has broad legal powers to require the First, IBRA’s Asset Management Credit unit is taking steps owners of debtor companies to provide additional assets to restructure the non-performing loans in its portfolio. and personal guarantees to secure these loans, such steps These restructured loans are then sold in financial sector have thus far done little to strengthen IBRA’s position as debt markets to generate cash. Second, IBRA’s Asset creditor. Frequently, obligors have argued that they have Management Investment unit is coordinating the strategic few additional assets to pledge that are not already under sale of assets pledged by conglomerates that received IBRA’s control (Murphy and Dipasena 2000). In some BLBI liquidity credits from the central bank. cases, indebted conglomerates have also apparently been able to draw on close ties to senior government officials to Overvalued Assets and Undercollateralized Loans IBRA’s debt restructuring efforts have been complicated 9 For the purposes of this audit, ‘fair value’ was defined as "the value of IBRA’s assets (in the form of bank loans, fixed assets, marketable securities or equity by the fact that the book value of the loans and other investment) that would be realized in the market according to appraisal data and/or assets held by the agency is much higher than their real the latest sales data available to IBRA" (IBRA 2001). 10 Financial ‘mark-up’ refers to the practice of artificially inflating the real value of a or fair value. An official audit of IBRA released in July 2001 project for which funding is sought in order to secure larger amounts of finance than found that the fair value of the agency’s total assets was Rp is actually needed. During the New Order period, the costs of large-scale investment projects were routinely marked up by 15 to 30 percent, and sometimes more. This 167.7 trillion (US$24 billion), or roughly one-quarter of gave the companies involved with such ventures considerable profits before the their book value, which amounted to Rp 645.8 trillion projects even began operating. For further details, see chapter 4.

108 elicit favorable treatment during the debt restructuring process (Vatikiotis 2000; Dhume 2001). These Box 5.2: IBRA and the Texmaco ‘Bail Out’ circumstances have often led IBRA to provide obligors IBRA’s controversial restructuring agreement with the Texmaco with sharp discounts in the amount of debt they are Group offers one example of how the agency’s debt resolution expected to repay; to waive or suspend interest and penalty process has often favored large obligors. During the New payments; to extend the tenor of outstanding debts; and to Order period, Texmaco invested heavily in the production of serve as effective underwriter of indebted firms by machinery, textiles, and automobiles to become one of purchasing convertible bonds to cover portions of their Indonesia’s largest exporters (Dhume 2001). The group had debts (see Box 5.2). also announced plans before the financial crisis to develop two mega-scale pulp mills in Irian Jaya with a combined IBRA faces similar difficulties in securing repayment of processing capacity of 800,000 tonnes per year. When the the Rp 144 trillion (US$20 billion) in outstanding BLBI rupiah collapsed in late 1997, Texmaco-owner Marimutu liquidity credits. The State Auditing Agency’s official Sinivasan drew on his close ties to President Suharto to review of the BLBI scheme found that the banks receiving obtain more than US$1 billion in discounted export credits the emergency liquidity support provided collateral that is from the government’s bank Negara Indonesia (Tesoro 1999). worth only a fraction of the real value of the credits These and other loans associated with 16 affiliated (Kompas 2001b).11 These pledged assets were later companies were transferred to IBRA when Bank Negara transferred from Bank Indonesia to IBRA, suggesting that Indonesia was recapitalized. the latter now holds inadequate collateral for the liquidity In September 2000, IBRA signed a two-stage debt credits it is seeking to recover. In addition, the audit found restructuring agreement with Texmaco. In the first stage, all of that IBRA’s own records were often contradictory with the group’s indebted companies were placed under a newly regard to the actual amounts of BLBI loans that had been formed holding company, aptly named Newco. Then Newco transferred from Bank Indonesia. Such discrepancies have issued obligations in the form of exchangeable bonds, 70 percent of which were ‘purchased’ by IBRA and 30 percent of led Jakarta-based accounting firm Hans Tuanakotta and which were held by Texmaco (IBRA 2000c). In the second Mustofa to issue a disclaimer of opinion after auditing stage, all debts of the Texmaco subsidiaries that had been IBRA’s books for 1998, 1999, and 2000 (Kompas 2001a). placed in Newco were restructured. The tenor of these debts There has, likewise, been widespread speculation that were extended to 11 years, and it was agreed that Texmaco assets pledged to IBRA by BLBI recipients as part of the would repay none of the principal on the loans for eight years Master Settlement and Acquisition Agreements have been (Kompas 2001d). In effect, the group was required only to overvalued (Bisnis Indonesia 2000a). In some cases, it is make interest payments during this period. likely that obligors have pledged companies that, in fact, Critics have claimed that IBRA’s restructuring agreement with have a negative value, as they are carrying substantial Texmaco amounts to a massive ‘bail out’ of a conglomerate with strong political connections (Kompas 2001d). They argue 11 The agency’s official audit of the BLBI found that recipient banks employed a that the agreement is aimed not at seeing Texmaco’s debt number of strategies to avoid fully collateralizing the credits allocated by Bank repaid, but at protecting the group’s cash flow position. In its Indonesia. Eleven banks, for instance, pledged bank shares, valued at Rp 2.4 trillion, and commercial notes, valued at Rp 1.0 trillion, without ever presenting the August 2001 Letter of Intent, the IMF, as well, called on the physical documents that would be needed for Bank Indonesia to take ownership of government to review the agreement. these in the event of default. In some cases, the audit found, recipient banks pledged assets to Bank Indonesia that had already been sold.

109 amounts of unpaid debt and are technically bankrupt. This in non-performing loans linked to timber, wood would appear to be the case, for instance, with at least a processing, and pulp and paper investments. portion of the companies pledged by the Bob Hasan These figures will rise even further to the extent that Group, now under the Kiani Wirudha holding company. IBRA writes off a similar percentage of non-forest sector Among other assets, the group has pledged its equity loans held by Indonesia’s forestry conglomerates. If it is shares in two forestry firms -- Kiani Kertas and Kiani assumed that, minimally, forestry conglomerates account Lestari—which together account for Rp 5.1 trillion for Rp 11 trillion in nonperforming loans from other (US$728 million) in nonperforming loans now held by sectors (excluding offshore debt), then a write-off on this IBRA’s Asset Management Credit unit (IBRA 2001). At the scale would amount to between Rp 5.5 trillion (US$786 very least, such a situation puts IBRA in the inherently million) and Rp 7.7 trillion (US$1.1 billion). Moreover, if it contradictory position of being a creditor to companies is assumed that IBRA fails to recover between 30 and 50 whose equity shares have been pledged as collateral to percent of the BLBI credits owed by the Salim and Hasan ensure repayment of BLBI credits. groups, the amount of forestry-related debt written off would rise by an additional Rp 11.4 trillion (US$1.6 billion) Projected Write-Off of Forestry Debts to Rp 19.0 trillion (US$2.7 billion). If IBRA achieves a Through August 2001, IBRA has reported a 20 percent similar recovery level for the US$1.3 billion in related- loan recovery level from its debt restructuring process party loans held by the Sinar Mas Group, projected debt (Dardani, et al. 2001). For forestry loans in its portfolio write-off for forestry obligors would increase further by that have not yet been restructured, the agency has also US$390 million to US$650 million. classified just over 20 percent of the total value of these Cumulatively, these figures suggest that IBRA may debts as having a high probability for recovery. These ultimately write off between US$4.4 billion and US$6.5 figures correspond roughly to Standard & Poor’s 1999 billion in debts associated with Indonesian forestry projection that Indonesian banks will require at least a 70 conglomerates. By releasing them from their obligations percent loan-loss provisioning level to cover that portion of to repay such a sizable portion of their outstanding loans, nonperforming loans that are unlikely ever to be IBRA will essentially be providing these groups with a recovered (Standard & Poor’s 1999).12 substantial new form of capital subsidy. To put these Based on these figures, it can be conservatively figures in perspective, debt write-off on this scale is estimated that IBRA will eventually write off between 50 roughly twice the US$2.7 billion that was calculated to and 70 percent of all non-performing loans associated with have been lost from the Reforestation Fund during the indebted forestry companies in its portfolio (Barr, et al. five-year period from 1993 through 1998 (Ernst & Young 2001). In aggregate terms, this suggests that IBRA is 1999). Similarly, these figures amount to four to five times likely to write off between Rp 10.9 trillion (US$1.6 billion) the US$1.2 billion in rents that the Apkindo plywood cartel and Rp 15.2 trillion (US$2.1 billion) of the Rp 21.7 trillion is estimated to have extracted from Indonesian panel

12 Some observers have suggested that this figure may, in fact, be quite optimistic. producers during the period 1985 to 1998 (Brown 1999, Indeed, former IBRA chair Glenn Yusuf offered a far more sobering forecast in cited in Barr, et al., forthcoming). November 1999, speculating that the government will eventually recover only 4 In all likelihood, a capital subsidy on this scale will percent and 3 percent, respectively, of nonperforming loans owed to state banks and nationalized private banks (Jakarta Post 1999a) provide the forestry sector’s major investors with a strong

110 incentive to continue—and in some cases, to expand— There is also a strong probability that many of the forestry their involvement in ventures characterized by high companies linked to IBRA are engaged in illegal activities. degrees of financial risk and/or socially and Under Indonesia’s HPH timber concession system, for environmentally unsustainable practices. This not only instance, logging companies have routinely harvested threatens to perpetuate degradation of Indonesia’s forests much larger volumes of wood than their concession at its current high rate, but also to create the conditions contracts allow (Kartodihardjo 1999). Likewise, on an for future financial collapse of many of the sector’s largest aggregate basis, Indonesia’s wood processing industries investors. Debt write-off as a form of capital subsidy takes have been estimated to consume as much as 56 million m3 on added significance when it is considered that very little of illegally harvested wood each year (Scotland, et al. new finance is currently being allocated by either 1999). As discussed in chapter 4, some forestry investors domestic or offshore banks to support forestry have also employed illegal ‘mark-up’ practices and transfer investments in Indonesia (Bisnis Indonesia 2001a). pricing schemes in financing their operations. The fact that IBRA controls such a large concentration PERPETUATION OF HIGH RISK of Indonesia’s forestry assets suggests that a unique AND ILLEGAL PRACTICES opportunity exists both to reduce the financial risks Many indebted forestry companies with loans or pledged associated with the nation’s timber and wood processing equity shares under IBRA are engaged in activities industries and to strengthen corporate governance in the characterized by a high degree of financial risk. These forestry sector. The regulations defining IBRA’s mandate include, for instance: give the agency broad authority to take whatever steps ______are necessary to protect the interests of the Indonesian capital-intensive pulp mills that have not secured a government in recapitalizing the nation’s banking sector. sustainable supply of raw materials; Under Government Regulation No. 17/1999, for instance, ______IBRA has been vested with far-reaching legal powers to wood processing firms that have installed rebuilt or exercise ownership responsibilities over banks under- second-hand equipment as a means of ‘marking up’ their going restructuring; to call in outstanding loans held by investment costs; ______these banks; and to dissolve commercial contracts large-scale plantation projects being developed on lands (Setiono and Manurung 2001). Broadly interpreted, these which are subject to tenure disputes with local powers give IBRA the authority to assume financial con- communities; trol, if not outright ownership, over virtually all of the ______companies with loans or pledged assets in the agency’s pulp and paper processing facilities involved in portfolio. environmentally hazardous practices with significant IBRA, however, has defined its fiduciary responsibilities negative impacts on the livelihoods of surrounding over these corporate assets in very narrow terms. In communities. interviews, IBRA officials have vehemently denied that the ______agency is effectively the owner of these assets.13 In their timber concession-holders that are unable to keep illegal loggers from harvesting trees within their HPH sites. view, the agency’s role is essentially that of a creditor— ______albeit one with extraordinary legal powers. Like a bank,

111 they maintain, IBRA’s responsibility is to collect the types of high risk or illegal practices outlined above. outstanding loans and credits in its portfolio. The agency Indeed, senior IBRA officers have indicated that they view has little concern over how an indebted company is practices such as overharvesting by timber concession- managed as long as it pays its debts. holders and the use of illegally harvested logs by wood processors as being regulatory problems that should be ‘Hands-Off’ Management handled by the Ministry of Forestry and relevant law In practical terms, this approach has meant that IBRA has enforcement agencies.15 They maintain that IBRA has taken very few steps to ensure that debtor firms are run in neither the institutional capacity nor the fiduciary a fully legal and commercially responsible manner. On the responsibility to enforce government laws outside the contrary, IBRA has left these companies under the finance sector. management of their original owners, who are allowed to IBRA’s loose oversight of how indebted companies are operate these enterprises with little direct oversight or managed also has implications for the future value of monitoring. In the case of businesses that were pledged to those firms’ commercial assets. It is conceivable, for IBRA by conglomerates whose banks received BLBI instance, that companies with debts or equity shares support, IBRA has placed these firms in holding pledged to IBRA would operate in a manner that involves companies to keep each group’s assets together. These running down their productive assets. In the case of a holding companies, too, are managed by the major plywood or pulp mill, this could mean that the company shareholders of the BLBI recipient banks, although IBRA fails to maintain its processing facility, diverting funds is represented on their boards of directors. While normally allocated for replacement parts to other uses. representation at this level may give IBRA some broad For an HPH-holder, it could mean that the company measure of oversight, the day-to-day management of the reduces the diameter of the trees that it cuts and extracts pledged companies and almost all cash flow decisions are an increasingly unsustainable volume of logs from its handled by their owners.14 concession site. In either case, the asset loses at least a This ‘hands-off’ approach to asset management portion of its value over time, suggesting that IBRA’s suggests that IBRA has little concern for whether the chances of recovering debts held by such companies may forestry assets in its portfolio are associated with the diminish correspondingly. In the forestry sector, such practices often are also likely to imply further degradation 13 Interview with IBRA Chair I Putu Gede Ary Suta and Vice Chair Sumantri of the resource base. Slamet, Jakarta, July 31, 2001. Whether or not IBRA should behave as the owner - or potential owner - of the assets in its portfolio is not an entirely theoretical exercise. As part of the debt restructuring process being managed by IBRA’s Asset Management Credit unit, the agency typically agrees to enter into a ‘debt-to-equity’ or ‘debt-to-convertible bond’ swap with the companies whose debts are being restructured. Under such arrangements, if the firm fails to repay some or all of its obligations, IBRA ends up as a shareholder. 14 This arrangement has raised questions within the financial community. As one analyst put it: "What are the ethics of allowing a group of companies that have essentially embezzled several hundred million from the central bank to retain their assets and to pay this money back over time? Moreover, how is it that they have been left under the management of the same team that was running them before 15 Interview with IBRA Chair I Putu Gede Ary Suta and Vice Chair Sumantri the crisis?" (Confidential interview, Jakarta, March 10, 2000). Slamet, Jakarta, July 31, 2001.

112 Debt Restructuring Without Corporate Restructuring restructuring process for companies active in the forestry IBRA’s failure to fully assess the operations of indebted sector. On the one hand, they view the issues that would forestry companies extends to the debt restructuring be covered by these studies as falling under the jurisdic- process, as well. While the agency’s restructuring guide- tion of the Ministry of Forestry and other regulatory lines require a due diligence review of these actors’ agencies, and well outside of IBRA’s own realm of forestry activities, such reports are generally prepared by responsibility. Additionally, they believe that such meas- consulting firms hired by the debtor companies them- ures would complicate the debt restructuring process and selves (Setiono and Manurung 2001). Moreover, these make it much harder to reach agreement with debtor assessments focus almost exclusively on issues related to companies. Whatever the real merits of these arguments raw material supply and cash flow, and do not evaluate the may be, IBRA’s reluctance to fully assess debtors’ forestry extent to which forestry assets are being managed in a operations suggests that the agency is carrying out debt legal and sustainable manner. Nor do they assess the restructuring without making a serious effort to improve social or environmental impacts of these companies’ the corporate structure and operating practices of the operations, and the financial risks that may be associated companies involved. with these impacts. To the extent that IBRA addresses legality issues relat- GROWING RISKS FOR FORESTRY INVESTMENTS ed to forestry operations, it does so through a ‘technical However substantial, the high levels of financial risk and covenant’ which is attached to the Memorandum of illegal practices that were facilitated by capital subsidies Understanding and Credit Agreement with the firm whose and lack of due diligence prior to the 1997 financial crisis debts are being restructured (Setiono and Manurung were clearly not unique to investments made in 2001). Under the technical covenant, the debtor company Indonesia’s forestry sector. Similarly, there is no evidence agrees, among other things, that it will not use illegally to indicate that these factors played a central role in harvested wood to repay its debts. Once the restructuring catalyzing the country’s financial collapse when the 1997 agreement is signed, failure to abide by the terms of the crisis struck. There are, nonetheless, several factors that technical covenant constitutes default on the outstanding are specific to the forestry sector that suggest that these loan. However, monitoring and enforcement of these industries may face significantly higher levels of financial agreements is essentially left to the Ministry of Forestry.16 risk than other sectors in the years to come. These factors IBRA officials have expressed reluctance to incorporate imply that IBRA’s efforts to restructure forestry-related either a detailed technical forestry audit or social and debts without restructuring the companies involved could environmental impact assessments into the debt very well create conditions for financial instability in the future. 16 IBRA has been criticized by Indonesian environmental groups and other government agencies for the narrow scope of its technical covenant (Setiono and In many parts of the country, there are growing indica- Manurung 2001). A more encompassing version proposed by a working group of tions that Indonesia’s once-abundant timber resources the Inter-Departmental Committee on Forests requires indebted forestry companies have declined significantly both in terms of commercial to submit one-year and five-year work plans and environmental impact assessments; to carry out responsible forestry planning and to meet all forestry volumes and quality. As discussed in chapter 3, this has regulations; to stay current on all outstanding fees to the government; to post a meant that most concession-holders are now operating performance bond and to plant HTI sites within five years after the license is issued; and to abstain from using illegal wood. much closer to the margins of profitability than they were

113 in the past, and in many cases, timber companies are holders and plantation companies have become endemic dependent on illegal harvesting practices to maintain in most forest-rich provinces. In March 2000, for instance, existing revenue levels. With deforestation proceeding at a the Indonesian Forest Concessionaires Association pace of 1.6 million ha per year, a sizeable portion of (Asosiasi Pengusahaan Hutan Indonesia, APHI) reported Indonesia’s remaining commercial timber resources is that at least 50 of its member firms, with HPHs totaling 10 likely to be depleted over the next decade (Toha 2000). million ha, had been forced to suspend their operations Scotland, et al. (1999) estimate that the total area of following disputes with local residents in Kalimantan, unlogged production forest estate17 is currently only 17 Sulawesi, and Irian Jaya (Jakarta Post, March 18, 2000). million ha, and at least 5 million ha of this has already APHI also claimed that 77 logging companies in East been designated for conversion. The World Bank has, Kalimantan were then engaged in ongoing conflicts with likewise, projected that Sumatra’s remaining lowland communities, some of which had seized the firms’ heavy forests will be exhausted by 2005 (World Bank 2001). equipment and were demanding compensation totaling A second factor that has raised the financial risks billions of rupiah.18 associated with forestry investments is the rising A third factor contributing to higher levels of financial prevalence of conflicts between forestry industries and risk in Indonesia’s forest-based industries is the process of local communities. Under Suharto’s New Order regime, increasing decentralization within the government itself. the Indonesian government routinely used its coercive This process has weakened the central government’s apparatus to maintain tight control over local communities’ capacity to guarantee investors access to land and forest access to land and forest resources, and made it a policy resources, as it did during the Suharto era. There is to prohibit forest-dependent communities from challeng- currently a great deal of uncertainty as to how the rights ing the activities of timber and plantation companies and responsibilities associated with forest administration (Fried 1995). However, in the post-Suharto period, com- will be divided among the central government, provincial munities have become increasingly assertive in demand- governments and district agencies. Since the ing recognition of local tenure claims and compensation decentralization process began, however, provincial and for resources appropriated, foregone earnings, and district governments have taken steps to redistribute environmental damages. In many cases, conflicts over land commercially valuable forestlands, and to raise their share and forest resources have put local communities in direct of timber revenues by imposing a number of new fees and confrontations with both companies and government royalties on HPH-holders. agencies. Weak law enforcement represents a fourth major risk The suspension of operations since 1998 at the US$600 factor affecting the financial viability of timber producers million Indorayon pulp mill in North Sumatra, following and wood processors. The widespread prevalence of violent conflicts with local communities, offers perhaps the most dramatic example of the financial risks involved 18 More recently, in August 2001, the Indonesian Forestry Society (Masyarakat Perhutanan Indonesia, MPI) reported that 213 HPH-holders with concessions in socially and environmentally damaging practices (see covering 19 million ha had stopped operating during the last two years (Bisnis Box 4.1). Similar conflicts involving timber concession- Indonesia 2001b). This represents just under one-third of the 61 million ha managed by the 569 concession-holders that were active in 1999. The head of the 17 This includes areas designated as production forest, limited production forest, MPI pointed out that the closure of these concessions has created raw material and conversion forest. supply shortages for many Indonesian wood processors.

114 illegal logging in most timber-rich provinces has made it heavily indebted conglomerates. IBRA officials and finance extremely difficult for many HPH-holders and plantation sector decision-makers are concerned that the collapse of companies to secure their forestry assets. Wood theft and indebted pulp and paper producers would effectively acts of arson can cut deeply into the long-term profitability inhibit the repayment of debts much larger than the cost of such ventures. of the mills themselves. Collectively, these factors suggest that the risks IBRA, for instance, has allowed Bob Hasan’s Kiani associated with forestry sector investments in Indonesia Kertas mill—the seventh largest debtor company in the are now significantly higher than they were for much of agency’s portfolio—to continue running its pulp facilities Suharto’s New Order period. Moreover, they imply that in spite of the fact that the group is technically insolvent. for the foreseeable future, forestry sector investments are IBRA officials have claimed that keeping the mill in likely to face substantially greater risks than most other business is a necessary condition for IBRA to recoup close sectors of the economy. Under these circumstances, it is to US$900 billion in Bank Indonesia liquidity credits from reasonable to assume that many of the forestry companies the Hasan Group. IBRA officials have complained, more- now undergoing debt restructuring with IBRA will oever, that due to the high investment costs associated encounter serious financial difficulties in the years ahead. with Kiani Kertas, any effort to sell the mill will yield only By restructuring their debts without restructuring the a fraction of its US$1.3 billion book value (Pulp & Paper companies, themselves, IBRA would appear to be pushing Online 1998). the sector’s financial problems into the future. At times, the corporate debt resolution process in Indonesia’s forestry sector has been linked to the DEBT-DRIVEN EXPANSION AND MORAL HAZARD expansion of high-risk activities. In the case of the Raja In spite of the enormous loads of capital debt that they are Garuda Mas/APRIL group, for example, both IBRA and carrying, most of Indonesia’s forestry conglomerates have international creditors have tied debt rescheduling to the been able to keep large portions of their timber, installation of new processing lines at the group’s Riau plantations, and wood processing operations running since Andalan pulp facility (Jakarta Post 1999b). Their stated the onset of the 1997 financial crisis. Most notably, none of rationale has been that Raja Garuda Mas/APRIL will be Indonesia’s major pulp and paper producers has been able to repay its debts sooner if it is able to expand the forced to halt its operations due to bankruptcy, in spite of volume of pulp that it produces. In entering into this the fact that their parent conglomerates are carrying over arrangement, IBRA and the group’s other creditors have US$17 billion in outstanding obligations. apparently given little consideration to the financial risks Paradoxically, the capacity of these companies to associated with the impending fiber supply deficits at continue operating has been due, in no small part, to the APRIL’s Riau mill, which will be exacerbated considerably fact that these groups owe so much money. Domestic by the recent expansion (see chapter 4). policymakers and international financial institutions, alike, For Indonesia’s largest pulp and paper producer, the have signaled that the country’s largest mills are ‘too big Sinar Mas/APP group, the financial risks associated with to fail.’ Not only did they account for US$3 billion in much- impending fiber shortages are compounded significantly needed exchange earnings in 2000; they also represent by the group’s unsustainable debt load. In fact, through the core productive assets for some of Indonesia’s most the first three years of the crisis, Sinar Mas/APP pursued

115 a debt management strategy that involved borrowing running—and in some cases to assist them in expanding -- substantial amounts of new capital to pay off existing suggests that the aggressive borrowing strategies used by debts. From mid-1997 through mid-2000, the group the industry’s largest producers have been characterized borrowed over US$3 billion in new funds, bringing its by a significant degree of moral hazard.19 In short, each of outstanding obligations to US$13.4 billion (Webb 2001e). these conglomerates seems to have calculated that if its During this period, Sinar Mas/APP was the only major debt levels were sufficiently large, others would be forced Indonesian conglomerate able to maintain access to to bear much of the costs in the event of a default -- as, international capital markets, and its heavy borrowing indeed, IBRA and creditor groups are now doing. placed it among the world’s largest emerging market It is important to recognize that the costs associated corporate debtors. In 1999 and 2000, the Indonesian with restructuring these companies’ debts cannot be government also injected close to US$900 million into quantified in purely financial terms alone. Indeed, the Sinar Mas-owned Bank Internasional Indonesia as part of substantial debt burdens associated with these mills will the IMF-sponsored bank recapitalization program (Sender likely translate into added pressures on Indonesia’s 1999). forests. This is particularly the case with the country’s Sinar Mas/APP’s spectacular financial collapse since largest pulp mills, which are now seeking new sources of mid-2000 suggests that the group’s debt-driven strategy cheap fiber due to plantation shortfalls that are projected carried enormous risks. There are strong indications that to last for at least the next several years. Carrying heavy Sinar Mas/APP pursued such a strategy because the debt loads, these producers must run their mills near full group’s principal owners recognized that in the event of a capacity to keep up with their high finance costs. At the major default, they would not necessarily have to repay all same time, cash flow constraints are likely to discourage of the money borrowed. Within Indonesia, Sinar these groups from making significant new investments in Mas/APP’s debt had reached levels large enough to have long-term plantation development, thereby exacerbating serious negative consequences for the country’s the fiber shortages their mills will face in the future. macroeconomy if it went unpaid (Adityaswara 2001). This meant that the Indonesian government would effectively be forced to cover some portion of the group’s obligations if Sinar Mas/APP were unable to do so. Indeed, when the group’s default seemed imminent in January 2001, the government quickly took steps to guarantee over US$1.2 billion in outstanding related-party loans from Bank Internasional Indonesia to Sinar Mas affiliates. Ministry of Finance officials argued that to do otherwise threatened to trigger a second collapse of Indonesia’s recently recapitalized banking sector and put heavy negative pressure on the already weak rupiah (Adityaswara 2001). 19 The term ‘moral hazard’ is used to describe a situation in which economic The fact that public funds are being used to keep actors have a perverse incentive to behave in an excessively risky or cost-incurring Indonesia’s highly indebted pulp and paper mills manner because the costs associated with such behavior will be borne by others.

116 DEBT STRATEGIES OF FORESTRY value of the asset. Instead, the agency worked out a CONGLOMERATES: THREE CASE STUDIES repayment arrangement under which Hasan’s group The following sections trace, in some detail, the specific pledged 30 companies to IBRA as collateral for returning manner in which three of Indonesia’s largest forestry the BLBI liquidity credits over a set period of time conglomerates have sought to manage their debts since (Kompas 1999). Although the specific terms of the the 1997 financial crisis began. These include each of the agreement have not been made public, the length of time three groups mentioned in the preceding section: the Bob for repayment has been reported variously as being either Hasan Group; the Raja Garuda Mas/APRIL Group; and three or five years (Ausnewz 1999). In the meantime, the the Sinar Mas/APP Group. companies are allowed to continue operating under the control of the Bob Hasan Group, as long as they stay on BOB HASAN GROUP schedule in repaying the liquidity credits. In the early months of the 1997 financial crisis, the In addition to its obligations related to the BLBI Bob Hasan Group was one of the main beneficiaries of the liquidity credits, the Bob Hasan Group is responsible for government’s BLBI liquidity credit scheme. As part of the Rp 7.0 trillion (US$1.0 billion) in forestry sector loans held government’s broader effort to shore up the nation’s by IBRA, making it the obligor with the largest forestry commercial banking sector, Bank Indonesia transferred loans in the agency’s portfolio (Brown 2001). These some Rp 12 trillion (US$1.7 billion at an exchange rate of include Rp 2.8 trillion in loans held by Kiani Kertas and Rp Rp 7,000 per US$) to the Hasan Group’s Bank Umum 2.6 trillion in loans held by Kiani Lestari. These loans have Nasional between late 1997 and mid-1998 (Kompas 2000b). been transferred to IBRA by state and private banks that Bank Umum’s management reportedly passed on most have been closed, taken over, or are being recapitalized by of these funds to Hasan-owned companies, including the IBRA. As noted earlier, many of the companies associated group’s Kiani Kertas pulp mill in East Kalimantan, which with these loans have also been pledged to IBRA as part of received an unspecified amount to cover “cost over-runs” the group’s BLBI repayment agreement. Some financial as the plant was being constructed (Jakarta Post 1998). analysts have argued that at least a portion of these The BLBI funds were part of a long series of government companies are likely to have negative value due to their subsidies that were channeled to Kiani Kertas. Other heavy debt loads and technical insolvency. If it is assumed subsidies included at least US$300 million in loans from that 50 to 70 percent of the Hasan Group’s overall debt is four state banks, an allocation of US$100 million from the eventually written off, this would result in a subsidy of government’s Reforestation Fund, and a 10-year tax US$500-700 million. holiday (see chapter 4). In October 2000, IBRA entered into a debt restructuring In September 1998, when IBRA moved to close Bank agreement with the Bob Hasan Group that covered some Umum Nasional for failure to repay the BI liquidity US$478 million in both ‘sustainable’ and ‘unsustainable’ credits, Hasan offered to surrender Kiani Kertas to the debt held by Kiani Kertas (IBRA 2000d). According to the bank restructuring agency in exchange for a US$1.3 terms of the agreement, IBRA has agreed to reschedule billion mark-down in its outstanding obligations (Jakarta US$226 million in so-called ‘sustainable debt’ with an Post 1999d). IBRA refused the offer, apparently believing extended repayment period of 10 years (due in 2010, with the book value of the mill to be far higher than the real a two-year grace period) and a fixed annual interest rate of

117 12 percent. IBRA has also agreed to purchase US$246 schedule. million in mandatory convertible bonds, which can be Over the longer term, limitations on the mill’s raw converted to equity at any time. material supply also threaten to place severe constraints In interviews, IBRA officials speculated that the agency on the company’s earnings. According to Kiani’s original would be able to recoup at most 50 percent of Kiani’s plan, the mill was to be fed by sustainably grown Acacia ‘sustainable debt’ when it is offered for sale. They wood from a 180,000 ha plantation run by an affiliated indicated, moreover, that they do not anticipate IBRA to company, Tanjung Redeb Hutani. To date, however, the obtain much, if any, cash value from Kiani’s ‘unsustainable company’s planting has been well behind schedule, and debt.’ To the extent that such projections turn out to be since the crisis began, the area planted has reportedly not accurate, they imply that IBRA will recover only US$113 exceeded 5,000 ha per year—or less than one-quarter of million of the US$478 million in debts held by Kiani its target (Ausnewz 1999; PT Tanjung Redeb Hutani 1996). Kertas—or below 25 percent of the total amount due. It Industry analysts also report that the company faces should also be noted that the extended tenor and relative- considerable problems establishing the infrastructure it ly low interest rate of the restructured loan can be expect- will need to get the wood from the plantation site to the ed to ease the terms of repayment for Kiani quite mill when it is ready to harvest (Ausnewz 1999; Jaakko significantly. The implications of such a subsidy become Poyry 1998).22 somewhat more profound to the extent that the mill’s 20 The structure of the mill’s financing is reported to have involved US$530 million original price was marked up, as has been widely alleged in vendor finance; US$120 in offshore bank loans; US$510 million in domestic (see chapter 4).20 loans; and US$140 million in equity from Bob Hasan, the group’s major shareholder (Ausnewz 1999). If it is assumed that the real cost of the mill was on the order of In addition to the subsidy that a substantial debt write- US$600-800 million, as many analysts speculate, then Hasan would have actually off would entail, there is also a moral hazard issue contributed none of his own money and, in fact, would have raised at least US$360 million in excess finance in the form of loans. If 70 percent of the project’s domestic involved in keeping afloat a company that appears to carry loans (US$510 million) are now to be written off, the Hasan Group will be able to a high degree of financial risk. Since it began operating, avoid repaying some US$360 million - or roughly the same amount as the excess the mill has been run at approximately 50 percent of its finance raised. In short, these calculations suggest that the mill will ultimately cost the Hasan Group between US$240 million and US$440 million. total capacity due to liquidity shortages and a series of 21 Confidential communication with a pulp engineer at Tanjung Redeb, November technical problems (Ausnewz 1999). Pulp engineers 11, 2000. As this informant explained, "For a mill to run efficiently, it needs high levels of coordination between raw material supply and processing; proper use of familiar with the Kiani’s operations attribute many of these machinery and the right equipment in place; and spare parts on hand when technical problems to the fact that the mill was equipment breaks. Kiani has none of these. Equipment is being pushed to the max. constructed with rebuilt and, in many cases, subpar If the normal life of a part is three to four months, Kiani pushes it to six to eight months. The problem is, you never know when you are going to have a catastrophic equipment. Moreover, they report that the company has break-down. Normally, when a part needs to be replaced, a mill will run down its often failed to implement a regular maintenance program stocks to 30 percent or less. In Kiani’s case, the mill is run until a part breaks, then everything stops." at the mill, generally replacing parts only once they have 22 As significantly, the new political climate has raised questions as to whether the worn out.21 To the extent that such reports are accurate, mill will be able to get all the wood it needs (see Obidzinski and Barr 2001). Since they suggest that the mill’s productivity is constrained by the fall of Suharto, Hasan’s Kalimanis group has had several timber concessions revoked, including one in Berau, where Kiani Kertas is located. Partially for this structural factors that will likely undermine the reason, the mill has reportedly imported a substantial portion of its wood from profitability of its operations for the foreseeable future and Malaysia and Australia. This has added substantially to the cost of the company’s operations, and some analysts question whether the company will be able to lead to physical depreciation of the mill well ahead of maintain such a strategy through downswings in the world pulp market.

118 RAJA GARUDA MAS (APRIL) the Finnish export credit agency withdrew its support for When the financial crisis hit, the Raja Garuda Mas Group’s the deal citing political and economic volatility in Singapore-based holding company, APRIL, was holding Indonesia. Lacking the US$140 million needed to complete over US$2 billion in debt to offshore creditors (Ausnewz the project, APRIL was forced to suspend construction on 1999). This considerable debt load was problematic in that the new production line, while the paper machine much of the company’s dollar-denominated debt was in reportedly sat in a warehouse in Finland waiting to be the form of short-term liabilities or long-term liabilities shipped. APRIL was, likewise, forced to halt its US$520 that were then coming due. At the end of 1998, 54 percent million investment in RAPP’s second pulp line. of APRIL’s US$624 million in long-term debt was then In September 1999, APRIL secured a US$800 million maturing. Total current liabilities at that point amounted to debt restructuring agreement with its foreign creditors to US$1.1 billion, and an additional US$576 million was ease the company’s liquidity constraints (Jakarta Post scheduled to mature by the end of 2000. APRIL’s 1998 1999b). Significantly, the restructuring agreement was financial report shows the ratio of current liabilities to linked explicitly to expansion of the company’s pulp current assets was then four to one (Ausnewz 1999). production facilities. According to the terms of the plan, Two additional factors significantly complicated the APRIL’s creditors agreed to waive the company’s interest company’s liquidity crisis. First, the disruption of pulp payments for an initial period of 18 months, while the firm production at APRIL subsidiary, PT Inti Indorayon Utama, completed its debottlenecking efforts and phase A of the due to conflicts with communities surrounding the mill put installation of a second pulp line. Together, these two steps an added strain on the group’s cash flow and threatened to expanded the company’s total pulp production capacity undermine the whole group’s financial ratings (see Box from 750,000 tonnes to 1.3 million tonnes per annum. 4.1). As noted above, banks and investor groups expressed Creditors reportedly agreed to help fund the US$520 growing concerns over Indorayon from mid-1998 onward, million capacity expansion because the additional as the company’s losses mounted and it failed to stay production capacity promises to generate cash that APRIL current on its interest and debt payments. Second, APRIL can use to pay back existing debts. APRIL’s chief financial was in the process of expanding production capacity at its officer also noted that the debt restructuring agreement Riau Andalan Pulp and Paper (RAPP) facility in Kerinci, would help position the company to obtain new financing Sumatra when the crisis began. This expansion program for additional capacity expansion projects (Jakarta Post included the installation of a second 350,000 tonnes per 1999b). He indicated that APRIL had already begun to annum paper machine to double the plant’s paper capacity; seek investment funds to raise RAPP’s total pulp output to the installation of a new 450,000 tonnes per annum pulp its ultimate target of 2 million tonnes per annum and to line; and debottlenecking of RAPP’s first pulp line to raise complete installation of the second paper line. production capacity by 100,000 tonnes to 850,000 tonnes APRIL’s parent conglomerate, the Raja Garuda Mas per annum (Potter 1999; Pulp & Paper 1999). Group, has negotiated a similar debt rescheduling The new paper line was being developed under a joint arrangement with its largest domestic creditors, including venture arrangement with Finnish multinational UPM- IBRA. In April 2000, it was reported that IBRA and two of Kymmene, and was being financed in part by Finland’s the state banks that IBRA is recapitalizing had agreed to export credit agency (Potter 1999). In early 1998, however, restructure the debts of three APRIL subsidiaries, with an

119 aggregate value of Rp 9.6 trillion which then amounted to these funds to help finance a further expansion at its Riau US$1.3 billion (Bisnis Indonesia 2000b). These included: Andalan pulp facility. In June 2001, APRIL announced that PT Riaupulp (US$550 million), PT Riaupaper (US$280 it had completed a second phase of expansion on its newly million), and PT Riau Prima Energy (US$428 million).23 installed second pulp line, bringing the mill’s total pulp Like the agreement made with foreign creditors, APRIL’s production capacity to 2.0 million tonnes per annum domestic rescheduling plan involves an 18-month deferral (Paperloop.com 2001). Almost immediately thereafter, the of interest payments on outstanding debts in order to group also reported that it would be unable to make allow Raja Garuda Mas to resume its pulp and paper interest payments on some US$1.2 billion in debts due to a capacity expansion program (Bisnis Indonesia 2000b). sharp decline in world pulp prices (Webb 2001c). By early This interest deferral would amount to a US$165 million September, the New York Stock Exchange announced that subsidy for Raja Garuda Mas. Moreover, the group would it had suspended APRIL’s shares and would seek to have not be required to repay the principal on these debts until the company delisted, as its share price had remained 2006 (Kompas 2000a). below US$1.00 for over 30 days (Borsuk 2001). When the arrangement was announced, reports in the Indonesian business press criticized IBRA Chair Cacuk SINAR MAS (ASIA PULP AND PAPER) Sudarijanto for authorizing the debt rescheduling Through the 1990s, the Sinar Mas Group borrowed agreement without the plan first being approved by the heavily in offshore debt markets to finance its massive agency’s loan workout committee (Kompas 2000a). capacity expansions in the pulp and paper sector both in Apparently, IBRA and a consortium of domestic banks had Indonesia and China. Much of these funds were obtained initially negotiated the debt rescheduling arrangement through APP, the group’s Singapore-incorporated holding with Raja Garuda Mas in August 1999. At that time, company, which issued several billion dollars worth of however, former IBRA Chair Glenn Yusuf refused to sign bonds and commercial paper in global debt markets. By the agreement, claiming that it had been structured the onset of the Asian financial crisis, Sinar Mas/APP strictly to benefit Raja Garuda Mas. He pointed out that it ranked among the world’s largest ‘emerging market’ would be an improper use of public funds to allow the corporate debtors, carrying US$7.1 billion in outstanding APRIL subsidiaries to defer their interest payments when obligations on APP’s balance sheet at the end of 1997 the group has substantial offshore capital holdings. He (APP, cited in Ausnewz 1999). noted, in particular, that APRIL holds a 51 percent stake in This heavy debt load required Sinar Mas/APP to direct a 350,000 tonnes per annum uncoated woodfree paper mill a very substantial portion of its earnings to cover in Changshu, China. IBRA has not formally explained how financing costs. Short-term obligations and long-term Mr. Yusuf’s successor arrived at his decision to support maturities that came due in 1997 amounted to just under the rescheduling agreement. US$1.0 billion. Maturities of APP’s long-term debt (i.e., In August 2000, APRIL cashed in on its China holdings, excluding short-term borrowing) were scheduled to climb selling its share in the Changshu paper mill to UPM- to US$875 million in 1998 and to US$1.4 billion in both Kymmene for US$150 million. The group apparently used 1999 and 2000, respectively (APP, cited in Ausnewz 1999). Adding to the group’s precarious financial position, Bank 23 These dollar figures reflect the companies’ rupiah-denominated debts converted at the April 2000 exchange rate of Rp 7,600 per US$. Internasional Indonesia, owned by Sinar Mas/APP, faced

120 effective insolvency through 1998. By the end of that year, access international financial markets in the years since the bank had a negative shareholder value of Rp 7 trillion, the crisis began. or US$1.0 billion at an exchange rate of Rp 7,000 per Much of the new debt taken on by the Sinar Mas/APP US$(Sender 1999). Financial analysts then estimated that group from 1998 through 2000 came in the form of direct the bank would need a capital injection of Rp 11 trillion— capital loans from international investment banks. Bank or US$1.6 billion—to stay afloat (Asia Pulse 1999). loans are typically short-term in nature, and those Until the group’s spectacular financial collapse in late extended to Sinar Mas/APP after the crisis began often 2000, Sinar Mas/APP pursued a two-pronged strategy to carried high interest rates due to Indonesia’s increased protect its core assets after the financial crisis struck. On risk premiums. In July 2000, for instance, APP borrowed the one hand, the group took steps to retain control over US$100 million at a rate of 25 percent (Rubin 2000). In Bank Internasional Indonesia by ensuring that the bank hindsight, financial analysts have noted that the lending qualified for IBRA’s recapitalization program. Specifically, banks did not seem to be concerned by the fact that Sinar Sinar Mas channeled US$628 million into the bank, or 40 Mas/APP was already carrying US$10 billion in percent of the funds needed to raise the bank’s capital outstanding obligations on its balance sheet and was using adequacy ratio to the required level of 4 percent. The much of its new debt to pay off old debt (Shari 2001). One government, in turn, injected Rp 6.6 trillion (US$942 Singapore-based banker interviewed in February 2000 million) in government recapitalization funds (Sender described the company’s situation as follows: 1999).24 It did so in spite of the fact that Bank Internasional Indonesia then carried on its books US$1.3 billion in outstanding loans to companies affiliated with Sinar Mas (Reuters 2001a). On the other hand, Sinar Mas/APP went to great lengths to stay current on the group’s interest and debt payments. To generate the large amounts of capital 24 Sinar Mas raised these funds through two separate rights issues, carried out in April and June of 1999. Bank Internasional Indonesia’s major shareholders were needed, Sinar Mas/APP initially took steps to postpone able to use these rights issues not only to obtain the funds needed for the bank’s new investments and to sell its noncore assets.25 Within a recapitalization, but also to secure an extra US$100 million through a little-seen loop-hole. Sender (1999) describes this process: "Those fortunate to have short time, however, the group reverted to a more familiar subscribed to the April issue were granted options giving them the rights to strategy of securing funds by taking on more debt. Asia subscribe to the second offer at a price of Rp 125 - a bargain considering that the Pulp and Paper’s balance sheet shows that over 1998 and average price of BII’s shares rose to Rp 200 after the earlier issue. That meant that anyone with the option could buy the shares at below-market prices and make a 1999, the company assumed over US$2.9 billion in new quick profit by selling them on the secondary market. That would have been fine interest-bearing debt (APP 2000). This figure is except that fund managers and analysts claim they weren’t informed in April of the right to subscribe to the second rights offer at the old exercise price. Therefore, particularly striking in light of the fact that international most of the second rights offer was taken up at the preferential price by the financial flows to Indonesian conglomerates, and to Widjaja family, which controls both Sinar Mas and the bank. [One analyst companies with heavy exposure in Indonesia, had slowed complained], ‘It’s like announcing the winning number in a lottery after you know what number you’ve drawn.’" to little more than a trickle since the onset of the 1997 25 APP’s most significant asset disposals have included the sale of power plants crisis. In fact, Sinar Mas/APP stands alone as the only attached to the group’s mills in both Indonesia and China to Singapore Power, Ltd, that country’s main electricity utility. More recently, Sinar Mas/APP has been major Indonesia-based conglomerate that was able to seeking to sell a large packaging facility attached to its Indah Kiat plant at Serang.

121 In this business, you’re not broke as long as someone will began to unravel in mid-2000. At that time, mounting lend you money. And the banks are tripping over short-term debts put severe constraints on the group’s themselves to loan money to APP. A big part of this is that ability to meet long-term obligations as they came due. APP is staying current on its payments, and as long as Global paper prices also dropped sharply relative to pulp they continue to do so, there’s always going to be someone prices, putting heavy pressures on Sinar Mas/APP’s cash who will give them new credit.26 flow.29 Anticipating that it would be unable to make payments on nearly US$2 billion in long-term bond issues In addition to securing operating loans from maturing in October 2000, APP applied to the United international banks, Sinar Mas/APP also made an effort to States Securities and Exchange Commission (SEC) for tap new lines of investment finance. In doing so, however, approval to approach creditors with an offer to raise the the group recognized that its pulp and paper operations in interest rates on some bonds in exchange for a longer Indonesia had reached a point where they were no longer payment period (Linebaugh 2000). News of the exchange able to expand in any significant way (Spek 2000; Ausnewz offer undermined investor confidence, and sent APP’s 1999).27 Sinar Mas/APP, therefore, shifted its financial share price plummeting. APP shares listed in New York strategy towards China, where the group has five paper closed the year at US$0.54, having lost 96 percent of their facilities. In April 1999, APP placed 48 million American value over the previous 12 months. depository shares on the New York Stock Exchange to In January 2001, the New York Stock Exchange obtain US$404 million for unspecified expansions at its suspended trading of APP shares and threatened the China projects (Hilsenrath 1999). In February 2000, APP company with delisting (Reuters 2001c). The following followed with a US$380 million bond issue—the month, two of Sinar Mas/APP’s Indonesian paper units— company’s first since the 1997 crisis—to obtain additional Tjiwi Kimia and Pindo Deli—failed to make coupon funds for its operations in China. Some analysts have payments on outstanding bonds. In March, the group speculated that Sinar Mas/APP channelled at least a announced that it had retained Credit Suisse First Boston portion of these funds to pay off the group’s existing debt to formulate a debt restructuring plan and JP Morgan to maturities as they came due.28 A report from Dow Jones coordinate strategic asset sales (Webb 2001e). This was Newswires described China, with its investment-grade followed almost immediately by an announcement that credit, as being a “proxy” for Indonesia’s Sinar Mas Group Sinar Mas/APP had suspended payments to all creditors. to reenter international bond markets (Pruitt 2000). The group’s total debts at that point stood at US$13.4 Sinar Mas/APP’s strategy of securing ever-increasing billion. sums of new debt to stay current on existing obligations In spite of the fact that most of its debt is owed to offshore creditors, the financial collapse of the Sinar 26 Confidential interview, Singapore, February 1, 2000. 27 Sinar Mas/APP’s pulp processing capacity in Indonesia is limited primarily by Mas Group has had profound implications for Indonesia’s the fact that the group’s plantations are not fully online and supplies of MTH within macroeconomy (Simanungkalit and Sasongko 2001). a commercial distance of the Sumatra mills are rapidly diminishing. On the paper and packaging side, the group’s processing capacity already well exceeds Sinar 29 In carrying out its large-scale capacity expansions in Indonesia and China Mas/APP’s pulp production capabilities, and the group is now facing the prospect of during the 1990s, Sinar Mas/APP had installed considerably more paper and needing to purchase over half of its pulp requirement from outside sources board capacity than its own pulp operations could support. As such, the group (Ausnewz 1999). has been forced to purchase 400,000 to 500,000 tonnes of hardwood pulp on 28 Confidential interview, Bogor, August 24, 2000. the open market each year.

122 Most immediately, it threatened to trigger the collapse of taken over Bank Internasional Indonesia, and has merged Bank Internasional Indonesia, the country’s second the bank with the largest state-owned lending institution, largest private-sector lending institution (Kagda 2001). Bank Mandiri. Through early 2001, Bank Internasional Indonesia still Creditor groups reportedly anticipate that the debt carried US$1.3 billion in loans to Sinar Mas affiliates, and resolution process with Sinar Mas/APP will take several these loans represented approximately 50 percent of the years to work out, and there is a strong likelihood that bank’s performing assets. Indonesian finance officials many of those with outstanding credits to the pulp and recognized that Sinar Mas/APP’s failure to repay these paper conglomerate will never be repaid (Webb 2001b). loans would result in enormous costs for the government. The position of international creditors, in particular, is If BII collapsed, the government would not only lose its weakened by the fact that the vast majority of Sinar recapitalization ‘investment’ (US$942 million), but it would Mas/APP’s productive assets are located in Indonesia also be required to pay out close to US$2.0 billion to the and China. Unlike Singapore, where APP is incorporated, bank’s depositors (Adityaswara 2001). More significantly, neither country has an effective bankruptcy court. One the failure of Bank Internasional Indonesia could easily fund manager who has traded in Asia Pulp and Paper catalyze a second financial crisis by undermining the distressed debts described the situation as follows: nation’s newly recapitalized banking sector. Even the In Singapore, the commercial courts strongly favor the prospect of the bank’s collapse put downward pressure creditor. If a company fails to repay its debts, the creditors on the rupiah. can sue, and the indebted company’s owner holds To preempt such negative impacts on the macro- unlimited personal liability to cover the debts. If debts go economy, the Indonesian government was effectively unpaid, the courts will also not hesitate to declare a forced to guarantee repayment of Bank Internasional company bankrupt and liquidate its assets. In Indonesia Indonesia’s related party loans. It did so in January 2001, and China, however, the courts strongly favor the debtor— in spite of the fact that APP was then showing clear signals particularly if the creditors are from overseas. The owners that it was close to defaulting on payments to some credi- of indebted companies are almost never held personally tors (Jakarta Post 2001d). In turn, the government liable for their companies’ debts.30 instructed IBRA to secure asset pledges from Sinar Mas/APP worth 145 percent of the group’s debts to Bank Many offshore bond-holders are concerned that Sinar Internasional Indonesia, as well as personal guarantees Mas/APP will work out debt repayment arrangements from the Widjaja family. IBRA has reportedly obtained with its Chinese and Indonesian creditors—including pledged assets from the group that are nominally valued at IBRA—that further undermine their chances of recovering Rp 23 trillion (Adityaswara 2001). These include land, the funds they have lent. Such fears are apparently not machines, and most other physical assets associated with unfounded. In March 2001, four Chinese banks, led by the the group’s pulp and paper operations in Indonesia. IBRA Bank of China, entered into a collective debt restructuring has also secured an option to assume equity control of agreement with APP aimed at ensuring repayment of Sinar Mas/APP’s pulpwood plantations and forestry US$1.8 billion in loans associated with the group’s China concessions, if the group fails to repay its loans to Bank Internasional Indonesia. In addition, the government has 30 Interview with Jason Brown, Jakarta, February 22, 2001.

123 operations (Webb 2001f). In exchange for an extended plantation companies will slow their planting schedules, repayment period, the agreement prohibits APP’s China scale back on plantation maintenance, and cut expenses operations from using their earnings to repay the group’s on research and development. However, reduction in area offshore creditors.31 In Indonesia, Sinar Mas/APP has, planted will mean that at least a portion of projected likewise, repeatedly made coupon payments to holders of Acacia yields will not be available for at least seven years its rupiah-denominated bonds, while payments on its forward, and possibly well beyond. This, in turn, will dollar-denominated debt remain suspended (Dow Jones create added incentives for APP’s pulp mills to ship in Newswire 2001). Some financial analysts have also pulpwood harvested from natural forest outside Sumatra questioned whether the assets that Sinar Mas/APP has and/or to rely increasingly on illegally harvested wood. pledged to IBRA may, in some cases, have been pledged to other creditors as well. Conclusion and Policy Options The fact that Sinar Mas/APP’s financial collapse has led The pace and extent of Indonesia’s macroeconomic the Indonesian government to assume such a direct stake recovery will largely depend on IBRA’s effectiveness in in the group’s debt holdings carries with it a very restructuring the nation’s banking sector and resolving significant degree of moral hazard. In addition to the the country’s corporate debt crisis. The specific manner in financial costs involved in guaranteeing the related-party which IBRA carries out these twin tasks will have loans from Bank Internasional Indonesia to Sinar Mas considerable repercussions for the forestry sector, in affiliates, the government is now under considerable particular, as IBRA currently holds a substantial portion of pressure to ensure that Sinar Mas/APP’s operations total corporate assets in Indonesia’s timber, plantation, and remain highly profitable. This is likely to create a strong wood processing industries. These include US$3 billion in incentive on the government’s part to keep the mill outstanding forestry-related loans, and approximately running at or near capacity, in spite of fluctuations in US$8.5 billion (nominally valued) in pledged equity shares prices for raw materials or products generated. At the or physical assets from three of Indonesia’s largest same time, restrictions on Sinar Mas/APP’s cash flow will forestry conglomerates: the Bob Hasan, Salim, and Sinar increase pressure to minimize operating costs at the Mas Groups. group’s pulp and paper facilities. A substantial portion of There are strong indications that IBRA will ultimately profits earned by APP’s operating units will be used to write off between US$4.4 billion and US$6.5 billion of the meet financial obligations incurred by the group’s holding forestry and non-forestry obligations held by these companies. groups. In doing so, the agency will effectively provide For Sinar Mas/APP’s forestry operations, this is likely Indonesia’s forestry conglomerates with a lucrative capital to mean a sharp reduction in further investments related subsidy at a time when little new finance is coming into to long-term sustainability. It is possible that the group’s the sector. In all likelihood, the allocation of a subsidy on

31 Specifically, the banks agreed to suspend APP’s debt payments for a period of this scale would provide these groups with a direct six months, and to provide the group’s operating units in China with letters of credit incentive to continue, or in some cases to expand, their to enable them to purchase raw materials and to engage in foreign trade. Under engagement in practices characterized by a high degree of the agreement, APP is required to allocate 80 percent of its China subsidiaries’ earnings to repay the Chinese banks, and to utilize the remaining 20 percent for financial risk. In the forestry sector, such practices have working capital. None of APP-China’s earnings may be used to repay debts outside often been associated with illegal logging, social conflict, of China. Draft (September 2, 2001) and environmental degradation. coordination between IBRA and member agencies of the The capital subsidy that Indonesian forestry Inter-Departmental Committee on Forests, most notably conglomerates receive through debt write-off could rise the Ministry of Forestry and the Ministry of Industry and significantly to the extent that international creditors are Trade. unable to recoup portions of the US$17 billion in dollar- To follow through on the government’s commitments to denominated debts that these groups now hold. The the Consultative Group on Indonesia, members of the recent financial collapse of Sinar Mas/APP, which alone Inter-Departmental Committee on Forests should work carries US$13.4 billion in corporate debt, suggests that the with IBRA to formulate a strategy for resolving Indonesia’s large-scale write-off of offshore forestry debts may well be forestry debt crisis. At the very least, this process should imminent. involve direct coordination among the Ministries of At present, the vast majority of forestry assets in IBRA’s Forestry, Industry and Trade, Finance, and State portfolio are still being managed by their original owners. Enterprises, the last of which has recently assumed Although IBRA holds wide-ranging authority to control the authority to oversee IBRA. operations of indebted companies, the agency has thus far exerted little fiduciary oversight to ensure that forestry A forestry debt policy initiative should debtors are being run in a fully legal and commercially focus on four things: responsible manner. Moreover, IBRA has done little to 1) Implementing an effective mechanism for supervision address forest management issues—including the social of forest sector companies under IBRA’s jurisdiction to and environmental impacts of forestry operations—during ensure that they are operating in a fully legal and the process of debt restructuring. In this way, the debts of commercially responsible manner. This should include many Indonesian forestry conglomerates are being public audits, ongoing monitoring by forestry experts, restructured, often on terms that are highly favorable to and a code of accountability for IBRA to ensure that the obligor, without any real steps being taken toward the agency meets its full fiduciary responsibilities. corporate restructuring. 2) Securing maximal financial accountability on the part Policy Options of forest sector debtors under IBRA. This should At the February 2000 meeting of the Consultative Group include full and timely repayment of debts by on Indonesia, the international donor community secured companies capable of repaying, and strategic a commitment from the Indonesian government to take downsizing or closures of companies unable to repay immediate action to ensure that debts held by forestry and/or deemed to be engaged in illegal practices. conglomerates were not written off. Specifically, the IBRA should also coordinate its debt resolution government agreed to “close heavily indebted wood process with domestic and offshore creditor groups to industries under the control of IBRA and [to] link help ensure that debtor firms bear the full cost of their proposed debt write-off to capacity reduction” (Keating overall financial obligations. 2000). To date, however, the government has done little to 3) Linking IBRA’s debt resolution process to broader put this policy commitment into operation. Implementation forestry sector policy goals. In particular, the Inter- has been hampered by poor communication and Departmental Committee on Forests should consider

125 to what extent IBRA’s debt resolution process can be used as a lever for reducing Indonesia’s overcapacity in wood processing industries and the reliance of these industries on illegally harvested logs.

4) Implementing an expanded code of financial due diligence for forestry investments. Fuller risk assessment will help ensure that investment banks and other financial institutions refrain from allocating future funds for illegal and/or inordinately risky practices in forestry sector industries. IBRA and other groups involved in the process of forestry sector debt restructuring also need more effective due diligence practices to better assess future risks associated with indebted forestry companies’ current operations.

126 Chapter 5 Sources Cited Dow Jones News Service. 1999. “S&P Cuts Indorayon’s Bond Ratings Adityaswara, Mirza. 2001. "BII: To Liquidate, Merge or Asset Swap?” to D; Off Watch.” April 1. Indosuez W.I. Carr Securities. February 2. Ernst & Young. 1999. “Special Audit of the Reforestation Fund, Final AFXAsia. 2001. “Indonesian Government to Guarantee Sinar Mas 12 Report.” Jakarta, December 27. Trillion Rupiah Debt to BII.” February 5. Fried, Stephanie. 1995. “Writing for Their Lives: Bentian Dayak Asia Pulp & Paper Company Ltd. (APP). 2000. “Form 20-F for Fiscal Authors and Indonesian Development Discourse.” Ph.D. Year Ended December 31, 1999.” Securities and Exchange dissertation, Cornell University. Commission, Washington, DC. Fung, Noel. 1999a. “Indonesia’s Indorayon Presents Debt Proposal to Asia Pulse. 1999. “Indonesian Government Capital Participation at BII Creditors.” Dow Jones News Service, June 29. 59.8 % of Fund.” July 6. Fung, Noel. 1999b. “Indonesia’s Indorayon ’98 Losses IDR 323.78 Asian Wall Street Journal. 1998. “Associate of Suharto Says His Firm Billion Vs IDR 444.01B.” Dow Jones Business News, May 2. Used Central bank Funds.” September 4. Hilsenrath, Jon. 1999. “Asia Pulp & Paper Completes ADS Sale, Raises Ausnewz Pulp & Paper Intelligence Service. 1999. “The Pulp and $404 Million.” Asian Wall Street Journal, April 26. Printing & Writing Paper Sector in Post-Suharto Indonesia.” Indonesian Bank Restructuring Agency (IBRA). 2001. Tekad Menuju North Hobart, Australia. Good Corporate Governance: IBRA Annual Report 2000. Jakarta. Barr, Christopher. 1998. “Bob Hasan, the Rise of Apkindo, and the Indonesian Bank Restructuring Agency (IBRA). 2000a. “Preliminary Shifting Dynamics of Control in Indonesia’s Timber Sector.” Information Memorandum on Holding Companies Under IBRA.” Cornell University (Indonesia) Modern Indonesia Project, No. 65, Asset Management Investment Division. pp. 1-36. Indonesian Bank Restructuring Agency (IBRA). 2000b. “Penangan Barr, Christopher, David Brown, Anne Casson, and David Kaimowitz. Restrukturisasi Sektor Forestry di BPPN.” Unpublished Forthcoming. “Corporate Debt and the Indonesian Forestry presentation prepared by Divisi Loan Workout, Forestry & Sector” in C. Colfer and I. Resosudarmo, eds., Which Way Agribusiness, August. Forward? Forests, Policy, and People in Indonesia. Washington, Indonesian Bank Restructuring Agency (IBRA). 2000c. “IBRA Starts DC: Resources for the Future. Expected publication 2001. Debt Restructuring at Texmaco Group.” Press release, October 5. Bisnis Indonesia. 2001a. “Peluang Investasi Sektor Kehutanan Makin Indonesian Bank Restructuring Agency (IBRA). 2000d. “IBRA Suram.” September 4. Restructures PT Kiani Kertas and Nusamba Group.” Press Bisnis Indonesia. 2001b. “213 HPH Tak Beroperasi, Industri Perkayuan release, October 5. Kritis.” August 29. Jaakko Poyry. 1998. Confidential Client Study, Jaakko Poyry Bisnis Indonesia. 2000a. “BPPN: Soal MSAA, Perlu Penyelesaian Saling Consulting (Asia-Pacific) Pte. Ltd., June. Menguntungkan.” September 26. Jakarta Post. 2001a. “Government Loses First Case on BLBI Funds.” Bisnis Indonesia. 2000b. “APRIL Debts Questioned.” English edition, June 20. April 12. Jakarta Post. 2001b. “IBRA Plans to Develop Four ‘Core’ Banks.” Borsuk, Richard. 2001. “NYSE Will Suspend, Delist Asia Pacific May 17. Resources.” Asian Wall Street Journal, September 3. Jakarta Post. 2001c. “Banks Fail to Meet CAR Requirement.” Brown, David W. 1999. “Addicted to Rent: Corporate and Spatial March 30. Distribution of Forest Resources in Indonesia; Implications for Jakarta Post. 2001d. “IBRA Assumes Sinar Mas Debt to Save Publicly Forest Sustainability and Government Policy.” DFID/Indonesia- Listed BII.” January 30. UK Tropical Forest Management Program, Report No. Jakarta Post. 1999a. “Only 4 Percent of State Banks’ Problem Loans PFM/EC/99/06. Can Be Recovered.” November 27. Brown, Timothy. 2001. “BPPN/IBRA Forest Sector Debt: A Brief Jakarta Post. 1999b. “APRIL Gets Relief to Expand Riau Pulp.” Analysis.” Unpublished memo, March 31, 2001. September 20. Cole, David C. and Betty F. Slade. 1996. Building a Modern Financial Jakarta Post. 1999c. “Government Suspends Indorayon Operation.” System: the Indonesian Experience. New York: Cambridge March 20. University Press. Jakarta Post. 1999d. “Kiani Kertas’ Debts to be Restructured.” Dardani, Saibansah, Eko Edi Caroko, Hisbullah Arief, and Mardiana December 8. Makmun. 2001. “Menggebrak Sarang Mafia.” Kapital, Jakarta Post. 1998. “Bob Hasan Questioned Over Bank Scam.” August 1-14. September 8. Dhume, Sadanand. 2001. “Texmaco’s Survival Guide.” Far Eastern Kagda, Shoeb. 2001. “Sinar Mas Troubles Threaten Indonesian Economic Review, August 9. Economy.” Business Times, January 23. Dow Jones Newswires. 2001. “APP Unit Pindo Deli Agrees to Pay Kartodihardjo, Hariadi. 1999. “Economic Loss of the State in Managing Rupiah Bondholders.” May 22. Natural Forest.” Unpublished paper prepared for Telapak

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129 Revitalizing Indonesia’s Forestry Reform Agenda

Chapter 6 This study has examined the prospects for sustainable Limited Effectiveness of HPH Concession Reform forest management in Indonesia within the context of the However useful the World Bank’s efforts were in opening structural adjustment and forestry reform processes that the door to forestry reform in Indonesia, the policy have occurred since the onset of the 1997 financial crisis. interventions put forth in the wake of the 1997 crisis have The analysis took as its starting point the forestry-related been largely ineffectual in terms of putting the nation’s policy conditionalities attached to the US$43 billion bail-out forestry sector on a more sustainable trajectory. In loan agreement signed by the IMF and the Indonesian particular, they have been constrained by the fact that the government in January 1998. Largely formulated by the country’s wood-based industries annually consume a World Bank, these policies served an important function in volume of timber that is two to three times the sustainable placing forest sector reform squarely on the agenda of harvest. Over the past decade, this ‘structural timber national decisionmakers at a time when Indonesia was deficit’ has fueled a sharp rise in illegal logging to supply undergoing rapid political and economic change. whatever volumes of wood cannot be produced by They held particular significance in that the Suharto Indonesia’s formal timber sector. In this context, the government, for three decades, had staunchly resisted Bank’s efforts to promote improved concession carrying out any measures in the forestry sector that management practices are extremely unlikely to bring threatened to reduce the flow of rents to the large timber removals down to levels even approaching the conglomerates that dominated Indonesia’s timber and government’s long-standing sustainability threshold of 25 plywood industries. Notably, the inclusion of forestry- million m3 per year. related conditionalities in the World Bank and IMF’s initial Additionally, the relative significance of HPH timber adjustment loan package also signaled that the multilateral concessions as a source of logs has declined markedly development banks would pursue environmental as well as since the early 1990s, as large numbers of concessions economic policy objectives in carrying out the structural have either been exhausted or taken out of production. At adjustment process. the national level, the Ministry of Forestry has sought to The policies initially proposed by the World Bank and compensate for the sharp decline in the volume of logs IMF were collectively aimed at promoting sustainable produced by the HPH system by making new wood forest management by reforming Indonesia’s HPH timber supplies available. In particular, it has allowed IPK permit concession system. As detailed in chapter 3, these holders to clear large areas of forestland that have been interventions drew heavily on the conventional slated for conversion to other uses. Indonesia’s rapidly “sustainable logging” paradigm that the Bank and others evolving process of decentralization has also meant that have long prescribed not only for Indonesia but also for provincial and district governments are now exerting practically every other timber-producing country in the increasing control over areas heretofore managed by HPH world. Key components included increased timber concession-holders. While HPH reform may have been the royalties, the introduction of performance bonds, key to sustainable forest management in Indonesia in the extension of the concession period, removal of prohibitive 1970s and 1980s, these trends suggest that the system is restrictions on the export of logs and processed wood now rapidly becoming obsolete and that growing volumes products, and independent monitoring to enforce selective of roundwood are being generated through increasingly cutting practices on the part of concessionaires. unsustainable practices.

130 The effectiveness of the World Bank’s effort to promote opposite effect. By peeling much smaller logs than the old sustainable concession management through increased rotaries, this new technology has created a demand for timber royalties has been limited by the fact that many younger trees and varieties of species that were previously HPH-holders are no longer obtaining the high levels of not commercially harvested. resource rents that they did in the past. With a decline in Finally, the potential effectiveness of the World Bank’s the volume of large-diameter, high-value logs at many HPH HPH reform strategy is severely constrained by the limited sites, a substantial number of Indonesia’s concessionaires political will and institutional capacity that currently exists are apparently operating much closer to the margins of within the Indonesian government. The weakening of the profitability than they were 10 to 15 years ago. This state since the fall of Suharto, together with the formal suggests that sustainable concession management may, in decentralization process, has shifted power decisively away fact, not be profitable for many logging companies. from the Ministry of Forestry in Jakarta. In much of Moreover, to the extent that sustainable management Indonesia, decisions regarding timber extraction and involves added costs, such as higher royalties and forest conversion are being made by local actors operating performance bonds, many timber companies can be largely beyond the reach of the central government’s expected to adopt increasingly unsustainable practices. planning and regulatory processes. The military and the Quite simply, concessionaires will not play by the rules if it national police force are also known to be heavily involved is not profitable for them to do so. in illegal logging in many provinces. While the World Bank The World Bank’s efforts to promote environmental has proposed the creation of a system of performance sustainability through increased efficiency in the timber bonds and independent monitoring to ensure sector face similar limitations. On the one hand, the Bank concessionaire compliance with the government’s HPH and the IMF have pressured the Indonesian government regulations, it is highly unlikely that such an arrangement to lift restrictions on log exports, so that domestic timber could work effectively without the active and coordinated producers can obtain world market prices for their wood. involvement of the government’s law enforcement The aim of this policy is to force the country’s wood agencies at each level of the state apparatus. processors to invest in efficiency and thereby to use smaller volumes of logs to produce the same or a greater Overcapacity and Financial Risk in Pulp and Paper volume of processed output. As discussed in chapter 3, To date, the forest policy reforms put forth by the World however, there is a strong likelihood that lifting log export Bank, IMF, and other members of the international donor restrictions before an effective chain of custody system is community have largely overlooked the enormous in place would put added pressure on Indonesian forests structural problems associated with rapid expansion of by encouraging higher levels of timber removals. Indonesia’s pulp and paper industries. The most significant On the other hand, the adoption of more efficient of these include substantial new pressures on natural harvesting and processing technologies does not forests, particularly in Sumatra, and high degrees of guarantee that the actual volume of wood being consumed financial risk. Indeed, producers have invested will necessarily drop. The introduction of small-spindle approximately US$15 billion to expand pulp and paper rotaries in many of Indonesia’s plywood mills over the past processing capacity by over 700 percent since the late few years, for instance, appears to be having quite the 1980s.

131 Currently, the nation’s pulp industry has an installed conglomerates that have made large-scale investments in production capacity of 6.1 million tonnes per year, implying Indonesia’s pulp and paper industry without first securing an annual wood consumption level of 29 million m3 if the legal and sustainable sources of raw materials have done industry were operating at full capacity. This volume would so, in part, because they have gotten heavy subsidies from amount to 40 to 50 percent of the country’s real annual the Indonesian government. Subsidies have included timber harvest at present. Before the financial crisis, cheap wood supplies; capital allocations from the processing capacity in the pulp industry was projected to Reforestation Fund; soft loans from state banks; and tax increase to 7.2 million tonnes by 2010. discounts and deferrals. Indirectly, the Suharto Investment in high-cost pulp and paper mills has government’s weak regulation of Indonesia’s financial proceeded far more rapidly than efforts by these sector have allowed these groups to discount their capital companies to establish sustainable pulpwood plantations. costs by making related-party loans from banks owned by Until now, most pulp mills have obtained the vast majority the same conglomerates making pulp and paper of their fiber from natural forest under IPK clear-cutting investments, and by ‘marking-up’ the cost of these permits and from undocumented sources. While each of projects. the mills is linked to HTI pulpwood plantation projects that Indonesia’s largest pulp and paper producers have relied involve fast-growing species, actual plantation yields are heavily on international sources of finance to support their likely to be substantially lower than those projected by the expansion over the past decade. Sinar Mas/APP is industry. In some cases, it would appear that Indonesian currently estimated to hold approximately US$12 billion in pulp producers may have artificially inflated their offshore debt, through bank loans, equity listings, and plantations’ growth rates and projected yields in order to international bond offerings. During the same period, Raja maintain access to global capital markets. Garuda Mas/APRIL obtained over US$2.0 billion in Indonesia’s two largest pulp mills—Indah Kiat Pulp & offshore debt. International financial institutions have been Paper and Riau Andalan Pulp & Paper—both face sizeable willing to channel funds to such high-risk ventures fiber supply deficits for at least the next seven years, and because they have employed weak due diligence possibly well beyond. Indah Kiat’s own sources of IPK procedures that have not adequately assessed the financial wood are likely to be finished by 2002, and industry risks involved. Also, industrial country export credit studies project that outside sources of IPK wood in Riau agencies have provided loan guarantees that have allowed will be exhausted by 2005. While the company’s pulpwood the banks themselves to avoid much of the risk associated plantation is expected to produce approximately 4.6 million with these projects. Often, export credit agencies have m3 of fiber by 2005, this will supply roughly one-half of the required the Indonesian government to sign counter- 9 million m3 of wood that the mill is likely to consume guarantees—thereby turning private risk into public risk. each year. In a similar manner, RAPP’s plantation sites are also likely to generate no more than one-half of the 10 million m3 of wood that the mill is capable of consuming on an annual basis, through at least 2007. With sizeable fiber supply deficits looming, each of these mills is facing considerable financial risks. The

132 Capital Subsidies Through Debt Write-Off inevitable. Indonesia’s IMF-sponsored bank recapitalization process Thus far, IBRA has shown itself to have little inclination has placed a significant portion of the forestry sector’s or capacity to ensure that the forestry assets under its overall assets under the control of IBRA. These include control are managed in either a commercially or environ- US$3 billion in outstanding bank loans directly associated mentally responsible manner. In most cases, the agency with timber, plywood, and pulp processing facilities, as well has allowed the companies’ original owners to continue to as several billion dollars’ worth of pledged equity shares operate the firms in its portfolio, with little direct oversight and physical assets from the Salim, Bob Hasan, and Sinar from IBRA. Although IBRA technically has the authority to Mas/APP Groups. call in outstanding debts held by these companies and to To date, IBRA has been able to recover only a very change their management structures, the agency has small portion of the debts in its portfolio, and there are generally chosen not to do so. In the case of Hasan’s Kiani strong reasons to believe that the agency will write off at Kertas pulp mill, discussed in chapter 4, IBRA has allowed least 70 percent of the US$33 billion in outstanding the company to negotiate an arrangement whereby it may nonperforming loans that it now holds. There are also repay outstanding Bank Indonesia liquidity credits over an strong reasons to believe that IBRA will ultimately collect extended period of time, in spite of strong indications of only a portion of the US$4.9 billion in Bank Indonesia financial mismanagement and future financial risk. In the liquidity credits owed by the Salim and Hasan Groups, and case of the Raja Garuda Mas/APRIL group, both IBRA and the US$3.3 billion in guaranteed related-party loans that offshore creditors have linked debt restructuring to the Sinar Mas/APP conglomerate is obliged to repay. It is, further processing capacity expansions at the group’s Riau therefore, estimated that IBRA may ultimately write off pulp facility. between US$4.4 billion and US$6.5 billion in capital debts owed by the Indonesia’s forestry producers. Revitalizing the Forestry Reform Agenda Debt write-off on this scale would amount to a substan- This study has generated several conclusions that under- tial capital subsidy for a set of industries that is already score the need for a revitalization of Indonesia’s ongoing putting heavy pressures on Indonesia’s remaining natural forestry reform process. In perhaps oversimplified terms, forests. Moreover, it would allow many companies to the most important findings can be summarized as follow: continue operating in spite of the fact that they carry high First, efforts to reform Indonesia’s HPH timber levels of financial risk. This could create the conditions for concession system and to improve efficiency levels their financial collapse in the future, which would almost among wood processors are highly unlikely to achieve certainly carry with it a considerable degree of moral their stated aim of promoting sustainable forest hazard. There is also a strong possibility that the amount management. of forestry debt that is ultimately written off could rise considerably if offshore creditors are unable to secure full Second, the rapid expansion of Indonesia’s pulp and repayment of the US$17 billion in dollar-denominated debt paper industries over the past decade has placed that Indonesian forestry conglomerates now hold. The profound new pressures on the nation’s remaining financial collapse of the Sinar Mas/APP Group suggests natural forests and has been characterized by a that large-scale write-offs by offshore creditors may be considerable degree of financial risk and moral hazard.

133 Third, decisions made by financial institutions and by sketch out the significance of these particular policy financial sector regulatory agencies such as IBRA priorities and how they might be implemented most often have a far more direct impact on forest effectively. management practices than government policies in the forestry sector itself. Limiting Demand for Timber and Pulpwood The considerable logistical difficulties associated with These conclusions suggest that the forestry reform controlling log supply in Indonesia suggest that any process in Indonesia will have greatest impact if it serious effort to relieve pressures on the nation’s focuses on achieving five specific policy objectives. remaining natural forests should involve proactive steps These include: to limit demand for wood on the part of domestic forest- based industries. With illegal logging going virtually 1) Limiting demand for timber and pulpwood; unchecked in most timber-producing provinces, it is 2) Slowing forest conversion; probable that Indonesia’s annual log harvest will greatly exceed the legal and sustainable harvesting levels as long 3) Strengthening codes of financial due diligence; as a substantial ‘structural timber deficit’ remains in 4) Designing an effective debt resolution strategy; place. Industrial overcapacity in Indonesia’s wood processing 5) Shifting the reform agenda towards equity. sector was identified as a critical problem facing the forestry sector at the February 2000 meeting of the Several of these policy objectives were identified as Consultative Group on Indonesia, placing the issue priorities at the February 2000 meeting of the squarely on the forestry sector policy agenda. There, Consultative Group on Indonesia in Jakarta. At that time, both the Indonesian government and the international the government made eight forestry-related agreements donor community agreed to take immediate steps to the international donor community. These include, towards “closing illegal sawmills” and “downsizing and among others, commitments to restructure the nation’s restructuring of [Indonesia’s] wood-based industry [in wood processing industries; to maintain the govern- order] to balance supply with demand for raw materials.” ment’s 1998 moratorium on natural forest conversion; and To implement these commitments, it will be necessary to close indebted forestry companies under IBRA. The for the Indonesian government and international donors government also initiated the formation of the Inter- to define practical steps that can be taken to reduce Departmental Committee on Forests to oversee imple- demand for wood on the part of domestic processing mentation of these commitments and to develop a industries, and to identify which agencies would need to National Forestry Plan. carry these out. It is significant that many of Indonesia’s Through October 2001, the IDCF has been slow to wood processors are now controlled, either in whole or in design effective strategies for carrying out the govern- part, by IBRA. To the extent that IBRA chooses to call in ment’s eight forestry-related commitments. However, the outstanding loans held by forest sector debtors, it can newly installed Megawati administration has shown signs exert a great deal of leverage in carrying out reductions that it is prepared to give high priority to forestry reform in processing capacity at both the firm and industry on its broader policy agenda. The sections that follow

134 levels. In playing such a role, it would clearly be reductions in roundwood harvests can only be achieved if necessary for IBRA to work closely with policymakers steps are taken to significantly reduce the pace at which from the Ministries of Forestry, Industry and Trade, State Indonesia’s remaining natural forests are being cleared Enertprises, and Finance, as well as a range of civil society and the land converted to other uses. To its credit, the organizations and forest industry experts. World Bank in late 1998 secured from the Indonesian A comprehensive forest industry restructuring strategy government a temporary moratorium on the allocation of would need to evaluate likely social and economic impacts forested land for conversion to oil palm and other of mill closures at the local, regional, and national levels. agroindustrial crops. This moratorium should be It would need to assess how displaced workers would find maintained at least until detailed surveys have been alternate employment, and the implications of forestry carried out to determine whether appropriate nonforested sector down-sizing on government revenues at each level areas are available for such projects, and until existing of the state apparatus. Moreover, policymakers would legal claims on such land have been resolved. Moreover, need to develop criteria for determining which mills efforts should be made to ensure that subsidies in the should be subject to capacity reduction measures or clo- form of underpriced IPK wood, discounted capital and sure. Minimally, such an initiative should include detailed loan guarantees, or corporate debt write-off do not offer and transparent assessments of whether: perverse incentives for agroindustrial enterprises and pulp ______producers to clear new tracts of forested land. these mills have verifiable access to legal and In addition, Indonesian government policymakers may sustainable raw material supplies; wish to consider placing restrictions on the allocation of ______new IPK licenses to pulp mills and other wood processors. their operations have a profoundly negative impact on Companies seeking access to IPK wood should be the surrounding environment; ______required to provide verifiable documentation that they are their activities have led to social conflicts that threaten making adequate progress in establishing plantations in either the viability of the processing enterprise or the order to ensure that their operations will eventually be socio-political stability of the region in which sustainable over the long term. Policymakers might also they are operating; consider requiring IPK license holders to pay higher ______royalties on the wood they harvest in order to ensure that the processing enterprise carries an inordinate degree its costs are comparable to the costs associated with of financial risk; ______obtaining fiber from pulpwood plantations. the company is associated with heavy debts that are Within the context of Indonesia’s ongoing likely to be written off at public expense. decentralization process, successful implementation of the ______government’s moratorium on forest conversion will require effective coordination among the national, Slowing Forest Conversion provincial, district, and village governments. A critical To the extent that policymakers do seek to control point of intervention will be the land-use planning process Indonesia’s wood supply, their focus will need to extend at thatdistrict level, as districts have assumed considerable beyond restricting log output from the HPH system. Sharp authority over forest administration and formal land-use

135 decisions under the new decentralization regulations. It mandated to withhold or to withdraw financial support will be particularly important to ensure that the spatial from forestry sector projects that are deemed to have a planning process is conducted in a genuinely participatory long-term dependence on unsustainable raw material manner and is based on sound technical principles to supplies. Similarly, restrictions should be placed on the ensure optimal utilization of forest and land resources. allocation of finance to companies whose activities are determined to have gross negative impacts on the Strengthening Codes of Financial Due Diligence environment and/or to be fueling social conflict with The large amounts of finance that have been allocated to communities in the areas where they are operating. Indonesian pulp mills without a secure raw material supply Finally, legal-regulatory mechanisms should be point to the need for financial institutions to adopt an established (or strengthened, if indeed they already exist) expanded code of due diligence for forestry investments. to hold financial institutions liable if they knowingly Such a code should be designed to ensure that financial provide funds to companies engaged in illegal activities. institutions fully assess the risks associated with the An investment bank realistically cannot be expected to projects they support and that they do not allocate funds if maintain an ongoing physical presence at a borrowing they are to be used for illegal activities. firm’s operations to determine the provenance of each log Legal-regulatory mechanisms should be established to that enters its pulp plant or plywood mill. However, it is ensure that such a code is employed by domestic financial reasonable to expect that a bank should commission an entities, including IBRA and private and state banks, as independent audit of a borrower’s raw material supply, and well as by international investment banks and export should be held liable if it knowingly funds a mill that has credit agencies. Minimally, such a code should require been documented to rely heavily on illegally obtained financial institutions to obtain an independent audit of a wood. Indeed, virtually every country in the world project’s long-term raw material supply strategy, as well as prohibits banks from lending money to support illegal its likely social and environmental impacts. Financial practices. institutions, moreover, should be required to carry out regular monitoring of the borrower’s adherence to this strategy for as long as they are involved in financing the project. In the case of new pulp mill expansion projects, for instance, the financial institutions involved should be obliged to require the borrower to submit a viable plan for establishing a dedicated and sustainable fiber source before new processing capacity comes online. Working with independent forestry experts, financial institutions could easily monitor a pulp producer’s efforts toward plantation development through the use of satellite images coupled with periodic ground-truthing. Under the new due diligence code, financial institutions should be legally

136 Designing an Effective Debt Resolution Strategy that IBRA may potentially write off is associated with Closely related to the issue of financial due diligence is the investments involving high degrees of financial risk and/or manner in which the large outstanding corporate debts illegal practices. Recognizing these factors, in February held by the forestry sector’s major investors are resolved. 2000, the Consultative Group on Indonesia adopted as one To the extent that IBRA writes off the non-performing of eight forest-related commitments an agreement to carry loans associated with investments in the timber, plywood, out the “closure of heavily-indebted wood industries under pulp, and paper industries, the agency will be channeling a the control of IBRA and linking proposed debt write-off to substantial capital subsidy to the relatively small number capacity reduction in the wood processing sector.” of conglomerates that dominate Indonesia’s forestry It is important to recognize that Indonesia’s sector. With private debt being converted to public debt in macroeconomic recovery will ultimately require some this way, the cost of debt write-off would initially be borne degree of corporate debt write-off. However, to avoid by taxpayers in industrialized donor countries that are creating the conditions for future financial crises and underwriting the financial restructuring of the Indonesian unrestrained pressures on Indonesia’s remaining forest economy. Ultimately, however, these costs will be borne by resources, it will be essential for IBRA to work with other the people of Indonesia. stakeholder groups to design an effective strategy for The costs involved in writing off corporate debts held by resolving the outstanding forestry debts in a responsible forestry producers are arguably much greater than the manner. These groups would include the Ministries of value of the specific loans or credits that are not recovered. Forestry, Industry and Trade, and Finance, and they On the one hand, as the World Bank has long maintained, should solicit active engagement with government large-scale subsidies to forest-based industries often agencies, civil society organizations, and donor groups. encourage concession-holders to employ unsustainable As outlined in chapter 5, this debt policy initiative should forest management practices and wood processors to focus on four major objectives: operate inefficiently. On the other hand, much of the debt

137 1) Implementing an effective mechanism for supervision control over the nation’s forests. Through the New Order of forest sector companies under IBRA’s jurisdiction to period, both the Ministry of Forestry and many ensure that they are operating in a financially sound advocates of the “sustainable logging” paradigm routinely and legal manner. This would include public audits, argued that large, privately owned logging companies ongoing monitoring, and the adoption of a code of connected to processing facilities are the most accountability for IBRA to ensure that the agency appropriate actors for managing areas designated as meets its full fiduciary responsibilities. production forest in Indonesia’s Outer Islands. The stated rationale was that such actors would have an incentive to 2) Securing maximal accountability on the part of manage their concessions sustainably because they have forestry sector debtors under IBRA’s jurisdiction. This both a long-term investment in processing that relies on should include full repayment of outstanding debts by continued access to timber supplies, and an economy of companies that are deemed to be capable of repaying; scale that enables them to run their harvesting and strategic downsizing or closure of companies operations efficiently. In this way, the principle of unable and/or unwilling to repay, as well as those sustainability has often been used to legitimize the determined to be engaged in illegal practices. extreme inequity around which the HPH system has 3) Linking IBRA’s debt resolution process to broader been structured over the past three decades. forestry sector policy goals. In particular, members of It appears that some large-scale timber operators may, the IDCF should consider the extent to which IBRA’s indeed, have adhered to the Indonesian government’s debt resolution process can be used as a lever for selective harvesting and replanting regulations. However, reducing Indonesia’s overcapacity in wood-processing a far larger number have employed indiscriminate industries and the reliance of these industries on logging practices to liquidate as rapidly as possible the illegally harvested logs. timber resources made available to them by the government. Recognizing sustainability to be untenable 4) Carrying out careful assessments of the medium- and makes it impossible to justify maintaining the New Order long-term financial risks associated with forest and regime’s policy of categorically excluding forest- estate crop companies in IBRA’s portfolio. These dependent communities from areas that the state has assessments should play a significant role in shaping defined to be production, protection, or conversion forest. the terms of repayment that IBRA negotiates with On the contrary, the demise of sustainability as an debtor firms, and in determining whether IBRA sells achievable policy goal suggests that equity for local the assets of companies who do not repay, or simply communities with clear historical or customary claims to closes their operations. forest land should, in fact, be a central principle guiding

Shifting the Agenda Toward Equity forestry sector reform in the present context. The legal recognition of local tenure would not, in Perhaps the most sobering conclusion to emerge from itself, guarantee that any given tract of forest would this study is that the sustainable management of remain standing longer than if it were managed by a Indonesia’s remaining forest resources may be timber concessionaire. It would, however, provide the fundamentally unachievable on any large scale. This begs basis for ensuring that members of forest-based the question of who, then, should have access to and

138 communities have legitimate authority to determine how Conclusion the forest resources on which their livelihoods depend Indonesian policymakers will clearly face considerable should be managed and to share equitably in the benefits challenges in implementing the reforms outlined in this of any products harvested from the areas within their study. Not the least of these is the need to integrate domain. Moreover, numerous studies have shown that equity and sustainability objectives in the forestry sector forest-dependent communities in many parts of Indonesia with the government’s broader strategy for are highly skilled resource managers who have sustained macroeconomic recovery. This will require decision- complex forest ecosystems for generations. Indonesia’s makers in the Ministry of Forestry to broaden their ongoing decentralization process has created an scope by working ‘cross-sectorally’ with their unprecedented opportunity for reorienting forestry counterparts in the Ministries of Finance, Industry and sector policy, planning, and regulatory processes so that Trade, and State Enterprises, as well as in IBRA itself. they are more directly responsive to the needs and Government agencies and civil society organizations interests of local communities. will also need to find ways to engage with one another In addition to strengthening tenure rights for forest- constructively in order to build broad-based support for dependent communities, an equity-oriented reform the forestry reform process. This process is certain to agenda in the forestry sector might include initiatives require difficult trade-offs that directly affect the interests such as the following: of a range of stakeholder groups. As such, it will be ______essential for the reform process to be carried out in a reorientation of large-scale plantation programs to genuinely transparent and consultative manner, building support the development of small-scale, locally on the significant degree of openness that has managed outgrower schemes; ______characterized the post-Suharto reform era thus far. use of unspent resources from the government’s multi- For forestry reform to succeed in Indonesia, it will also billion dollar Reforestation Fund to finance initiatives need to be closely tied to the nation’s ongoing aimed at poverty alleviation; decentralization process. Ultimately, policymakers at the ______national, provincial, district, and village levels will need to retraining of workers who will be displaced by forestry find some measure of agreement with regard to their sector restructuring; respective rights and responsibilities in the area of forest ______administration. The decentralization process holds a capacity-building for local people, village and district great deal of promise for making the government’s governments, and civil society organizations in areas regulation of forest management more responsive to the such as resource mapping, spatial planning, and needs of the millions of Indonesians whose livelihoods legal rights. depend upon these resources. Together with the reforms ______sketched above, increased accountability of this sort represents a critical step towards ensuring that Indonesia’s remaining natural forests are managed in a fully legal and sustainable manner.

139 Acronyms

AAC—Annual allowable cut HTI—Industrial timber plantations Adt—Air-dried metric tonne IBRA—Indonesian Bank Restructuring Agency Apkindo—Indonesian Wood Panel Association ICDF—Inter-Departmental Committee on Forests (Asosiasi Panel Kayu Indonesia) IHPH—HPH license fee APHI—Indonesian Forest Concessionaires Association IHH—Forest product royalty (Asosiasi Pengusahaan Hutan Indonesia) IMF—International Monetary Fund APKI—Indonesian Pulp and Paper Association IPK—Wood utilization permit (Izin Pemanfaaten Kayu) (Asosiasi Pulp dan Kertas Indonesia) JMB—Joint marketing board APP—Asia Pulp & Paper Company Ltd. m3—Cubic meters APRIL—Asia Pacific Resources International Ltd. Menko Ekuin—Coordinating Ministry for the Bappenas—National Planning Agency Economy, Finance, and Industry BFL—Basic Forestry Law (Undang-Undang MOFEC—Ministry of Forestry and Estate Crops Dasar Kehutanan) MTH—Mixed tropical hardwoods BHKP—Bleached hardwood kraft pulp NFP—National Forestry Program CGI—Consultative Group on Indonesia NGO—Non-governmental organization DR—Reforestation Fund PT TEL—PT Tanjung Enim Lestari GAAP—Generally accepted accounting procedures RAPP—Riau Andalan Pulp & Paper GDP—Gross domestic product Rp—Rupiah GNP—Gross national product tpa—Tonnes per annum GOI—Government of Indonesia WRI—World Resources Institute ha—Hectares HPH—Indonesia’s timber concession system or “Right of Forest Exploitation” (hak pengusahaan hutan)

140 by Christopher Barr

WWF Macroeconomics Program Office Center for International Forestry Research (CIFOR)

Photographers Bruce Bunting/WWF Banta D. Manullay Howard Buffett Peter Rodman ACROECONOMICS M